Smart residential property landlords run a credit check before entering into a lease agreement with a new tenant to help evaluate whether he or she will pay the monthly rent. Commercial tenants — even those backed by well-known, longstanding corporations — typically merit even more scrutiny. After all, financially stable, creditworthy tenants are essential if you’re going to make the most of your real estate investments.
Why is a tenant’s credit so vital to the financial success of your real estate? It’s not just about the steady income stream from rental payments. A tenant’s creditworthiness can affect your ability to borrow against your property, which in part depends on your tenants’ financial fitness.
It’s also relevant in buildout situations. A significant buildout can sometimes make it difficult to relet the property if the tenant defaults. Performing a credit check before leasing space to a tenant with specific buildout requirements provides added assurance that you won’t be put in that position.
Factors to Weigh
Effective creditworthiness assessments take a comprehensive view. You should routinely consider a variety of factors both before you enter a lease and throughout the lease term. These factors include the tenant’s:
- Business history,
- Place of incorporation,
- Financial statements (audited or reviewed statements are preferred to compiled or internally prepared ones),
- Revenue sources and their sustainability,
- Financial institution references,
- Rent history and landlord references,
- Legal history, including previous bankruptcy filings, liens and pending litigation,
- Management team strength, and
- Required terms, including those related to buildouts or other improvements.
You also should look at the tenant’s business plan to evaluate growth prospects and market share. Depending on location, a growing number of tenants are start-up or relatively young ventures that don’t have a lengthy financial or credit history. In these cases, landlords need to look beyond the more traditional factors identified above to consider how these tenants earn their money and whether their investors are creditworthy.
If the tenant is part of a national corporation, don’t assume that they’re as creditworthy as their parent company. Consider business unit–level profitability. Corporations can run into trouble and suddenly close locations, long before their lease terms expire. The units that survive such corporate shutdowns are usually the profitable locations. On the other hand, commercial real estate leases for cost centers, such as offices, call centers, bank branches and distribution hubs, could be the first on a troubled company’s chopping block.
Creditworthiness plays a prominent role when it comes to requiring credit enhancements from tenants who fall short of your criteria. The most common enhancement is a cash security deposit — the less creditworthy the tenant, the greater the amount of cash deposit you’ll require. The deposit requirement also should reflect costs to complete the transaction — for example, those related to construction, broker commissions and administrative tasks.
Some landlords go further, requiring letter of credit security deposits backed up by a third-party financial institution. The terms could allow you to draw on a letter of credit after tenant default without involving the tenant. Moreover, the financial institution may be obligated to pay you even if the tenant files for bankruptcy. However, some courts have ruled that letter of credit security deposits are part of the bankruptcy estate and, therefore, subject to the cap on landlord damages.
Be Safe, Not Sorry
Every commercial tenant doesn’t necessarily need a sterling credit history to lease space from you. But it’s good to know what you’re getting into ahead of time. Assessing credit helps you know when to add appropriate protections into a tenant’s lease agreement.
Sidebar: When a Guarantee Can Fill the Credit Gap
Sometimes a prospective tenant doesn’t meet your creditworthiness criteria and can’t provide a substantial cash deposit or a letter of credit. But that doesn’t necessarily mean you should walk away from the arrangement. A creditworthy third party may be willing to provide a guarantee to bridge the gap. The guarantor could be the tenant’s corporate parent or affiliate or an individual like the majority owner of the tenant business.
Ideally, you’d like a full guarantee, but most guarantors will provide only a limited guarantee. For example, a guarantor might agree to a guarantee with a maximum dollar cap on its liability (based on the value of the lease and your potential loss in case of tenant default) or a cap based on a formula. That formula could reflect your out-of-pocket expenses (for example, lease brokerage fees), an unamortized tenant improvement allowance, an allowance for recovering and preparing the space, and past due and pending rent.
Regardless of the guarantee type, review both the tenant’s and the guarantor’s financial information on a regular basis to ensure you continue to be protected.