Analyzing tenant default risk in commercial real estate

We discussed certain net lease capitalization rate (cap rate) components in a recent article. Today, we focus on breaking down one component, tenant default risk.

Tenant default risk is the possibility of a tenant defaulting on their lease obligations. The default may be monetary such as failing to pay rent when due, or in principle by failing to maintain the building to the standards required by the lease.

Net lease property owners must actively hold their tenant accountable during the lease term to increase their return on investment. Failure to monitor property conditions is a costly mistake that can result in hundreds of thousands of dollars of deferred maintenance expenses when a tenant leaves the property.

Financial default due to failure to make timely rent payments is a much more apparent type of default. Net lease investors should conduct careful due diligence into the tenant’s past performance at other properties. The selling broker and selling landlord probably aren’t going to divulge past defaults, failures to pay rent on time, and nuances of the tenant and landlord relationship. Net lease landlords should conduct research with other landlords to understand how the tenant interacts with their landlords.

Equally important is conducting a detailed analysis into a tenant’s financials, and understanding the findings of the research. We conduct in-depth analyses on behalf of net lease property buyers

We believe that understanding a tenant’s operational efficiency and ability to continue as a going concern requires looking at revenue, EBITDA, and store count growth over the past five years. 

Net lease investors should also analyze a tenant’s quick ratio and debt-to-capital ratio at a base level to understand a tenant’s liquidity risk, and then benchmark these ratios against competitors in the same industry. 

These ratios should be considered carefully, and it is important to understand that a tenant may have strong ratios, but low dollars in some areas. For example, $6.00 in cash and $1.00 in short term liabilities yields a quick ratio of 6.0. However, if the company has operating expenses of $400 M the $6.00 and 6.0 quick ratio could disappear quickly if the company experiences a decline in sales. 

In short, the best analysis is one that develops a full understanding of the tenant’s position. Net lease properties are meant to be held for a substantial amount of time. Investors should perform detailed acquisition underwriting to gain increased levels of comfort with their tenant’s ability to continue paying rent.