MJF 013 TENANT CREDIT ANALYSIS
There are four parts to Evaluating and Analysing a Shopping Center or Single-Tenant Net-Leased retail property for an investment. They are Location Evaluation, Credit Analysis, Financial Underwriting and Property Condition. These four factors are applicable regardless of the property being a Single-Tenant all the way to a Super-Regional Mall and everything in-between.
A lease is a granting of credit by the landlord to the tenant. The tenant is promising to pay a certain amount of money over the life of the lease and the property owner needs to verify that the stream of payments promised will be paid for the full term of the lease as agreed. Retail Real Estate leases are typically 3-5 years and can extend up to 50 years in length if a tenant is also granted options to extend the lease.
Since the leases are longer with Retail Real Estate Investment, an important factor to evaluate is the “Credit” of the tenants. Does the tenant have the ability or likelihood of paying the rent and keeping the commitments of the lease over a term of 5, 10, 15 or even 25 years (With options leases can extend for 50 or more years. For example, I have a Walgreens lease that was signed in 1957 (before ZIP Codes). In 2010 we renegotiated and renewed the lease (with rent bumps) so it now extends into 2045.
The credit of a Retail Real Estate tenant must be evaluated in the same way a bank will use your personal credit score to determine how much a it will lend to you and at what terms (interest rate and amortization). Similar to your personal credit score, a tenant’s “Credit Rating” refers to their financial strength and the likelihood of making payments throughout their lease term.
There are two basic types of tenants: Credit and Local. Credit tenants are larger chain stores, many publicly traded on the NYSE (New York Stock Exchange), LSE (London Stock Exchange), NASDAQ (National Association of Securities Dealers Automated Quotation System), TSE (Tokyo Stock Exchange/Japan Exchange Group), SSE (Shanghai Stock Exchange) and other smaller stock exchanges
The Investment Grade (IG) rating from Moody’s, Standard & Poor and Fitch are an important factor to consider along with the location aspects and condition of the property. Net-Leased Single-Tenant Retail properties have become highly sought after by individual investors, REITs, insurance companies, pension funds and other institutional investors. These larger, more sophisticated investors seek to invest in “Investment Grade” property assets which are tenants with credit ratings at least BBB- or higher by Fitch and Standard & Poor or Baa3 or higher by Moody’s. Many Net-Lease Single-Tenant Retail properties are leased to publicly traded companies such as CVS, Walgreens, Autozone, 7-11; Dollar General, McDonald’s, Chick-Fil-A, Starbucks, Walmart, Whole Foods, Hobby Lobby or Kroger. In this case it is easy to pull up investment research from reputable online stock analysis sources or a good site for the number of stores in a chain, sales growth trends and same store sales is: https://retail-index.emarketer.com .
There are a few grades of tenant below a “credit“ tenant. The less desirable type is the “unrated“ or more commonly known as “junk status“. These tenants either have massive amounts of debt with little prospect to pay or are a business which is borderline “Not Viable” or “Going Concern”. This means that they are at the steps of the bankruptcy court or have gone through bankruptcy and their prospects don’t look good to continue on in business.
You can also get a bond quote on “rated“ business that is not publicly traded. Some of these businesses, for example Meijer or Koch Industries are massive, financially strong businesses which may arguably have better credit than some of their publicly traded rivals.
For these and other smaller local or regional change you can get information that is sometimes available with some digging on the Internet or else you can pay for a report from Dun & Bradstreet.
With smaller tenants that don’t have a long operating history you can ask for bank or trade references along with financial statements for at least three years of operating history. If the tenant is a sole proprietor or is an entrepreneur looking to open up their first or second business, I would recommend running a personal credit check. Your lease should also include a personal guarantee for these types of tenants.
Local tenants are a valuable and much needed variety for shopping centers and retail real estate. Many large chains of today were a local tenant only a few years ago. A good case in point is Ulta Beauty, Inc. who grew from a single store in 1990 to the leading beauty supply store chain in the country with $5.9 Billion in sales for 2017. The retail real estate industry needs innovative local tenants to thrive.
A hybrid of credit tenant/local tenant are franchise stores/restaurants. Many large names in the retail real estate market have expanded through franchising their names and systems which also ensures a higher likelihood of success for the local entrepreneur who aligns themselves with the brand. For example, McDonald’s, the granddaddy of franchise restaurants, has made many franchisees fabulously wealthy. Many innovations in the Quick Service Restaurant (QSR or Fast Food) industry have been created by innovative franchisees like the whole category of, drive-thru, serving breakfast and being open late nights were invented by franchisees. You as the investor need to evaluate not only the chain and concept but also need to evaluate the individual franchisee guaranteeing the lease. Do they have operating experience? Do they have business experience? Some unethical franchise concepts exist mainly to sell as many franchises as possible and don’t really care about the profitability of the individual operator after the sale. There are also many franchise operators that are highly successful and operate hundreds of stores and even different franchise concepts. These operators have the credit of regional or smaller national chains.
When underwriting the purchase of a shopping center or building you can request from the seller if they have any of this information. Additionally for local tenants you should look into what type of security deposit the seller is holding. In certain situations with more financially savvy tenants, the property owner might hold a letter of credit ( LOC )instead of a security deposit. You would then have the ability to draw down on the letter of credit per the terms of the lease if the tenant should default. You as the purchaser want to make sure that the letter of credit is transferable to you or there is an amendment which names you the beneficiary with the right draw down to cover any event of default.
The credit of tenants also is an important factor in the pricing of the asset you wish to purchase. For example, let’s say you are deciding between two recently built, 20,000 square foot shopping centers to purchase. Both are relatively equal in every respect except one is anchored by a 13,500 square foot Walgreens with 5 local tenants and the other center has no anchor and 11 local tenants. All things being equal, the Walgreens lease represents 60% of the income stream and will more than likely be at the location for at least 20 years. So the Walgreens center would sell at a premium (higher price) than the center with more local tenants which may or may not be around for the five years on their lease.
More importantly, banks and other lenders also determine what they loan their money on by the type of tenants in the shopping center. In the early days of the shopping center industry, most lending on retail properties was done by insurance companies and then a little later also by pension funds. The lenders demanded at least 85% of the tenants be AAA or “Credit” tenants before they would loan on a new development. Now there are more borrowing options for investors but lenders still look to the credit of the tenants to decide the terms on a loan. You have a better chance of scoring a non-personally guaranteed loan with Walgreens as your main tenant because the long term lease ensures a higher likelihood of you paying your mortgage on time.
Credit is one of the important factors for evaluating the purchase and a major factor for pricing of Retail Real Estate.
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About the Author: Michael J. Flight
Let your investment dreams take flight with the expert help of Michael Flight, principal investor at Concordia Realty.
Michael has worked for more than 28 years and handled more than $500 million worth of real estate transactions on behalf of his clients at Concordia Realty. Michael began his business in the realm of retail real estate, with Concordia Realty now handling third-party property and asset management services for a variety of commercial real estate investments.
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