Commercial Lease Tenants and How to Qualify Them

Tips on Qualifying Tenants in a Commercial Lease

When investors buy a property, they almost always will do a property inspection, review the title report, examine the comparable sales, survey the lot and building, and take a good look at the competition.

But for some reason most will overlook reviewing the quality of the existing tenants.  True, you usually can't change the tenant, but it makes sense to at least know what you're getting into so that potential problems or other issues can be predicted and budgeted for.

One of the due diligence items we see buyers of homes for rent and commercial investment property overlook is the qualifying of the tenants currently in the property, regardless if it's a commercial lease or a residential lease.

Several years ago when the market was strong, if a tenant ended up 'going bad' a new replacement tenant could be found relatively quickly and a new commercial lease would be written without a reduction in rent.

The Realities of Today's Market Place

In today's market, if a sales transaction is being done at all, often it is a bank owned property or short sale property and the seller expects the buyer to accept the commercial lease as-is, in exchange for what it supposed to be a discounted sales price.

Investors become excited about buying a property 'below replacement cost' and fail to consider the importance of the commercial lease and how the property cash flow will be affected if one or two tenants are lost and the length of time it might take to find replacements at the same, or more likely, a reduced rental rate.

[The Basic Property Management eBook has several good pointers on analyzing a property before you buy it, how to thoroughly review a commercial lease, and on how to use your maintenance staff to gather tenant intelligence.  Check out the Property Management Training eBook here.]

 

A Real-Life Example with a Commercial Lease

Recently we began managing a multi-tenant commercial property for an owner who had purchased the retail shopping center as a short sale.  It quickly became apparent that the buyer had been focused solely on the price per square foot and on buying a building at a 'below market rate' with only a quick glance at the commercial lease that each tenant had signed.

Within 30 days of closing escrow the investor faced these situations with current tenants:

• An anchor tenant was on a month-to-month commercial lease and began negotiating for a lower rent
• Trying to collect rent that was 60 days past due from three of the tenants

Amazingly the buyer was aware of the above tenant situations but believed that through new ownership and good property management the tenants would voluntarily catch-up on their back rent and also re-sign each commercial lease even though they had above market rates.

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The reality is that if a tenant is not paying the old owner, they're not going to pay the new owner either.

Qualify Your Tenants

 

Here are 5 things you can do, before you invest in any real estate investment property, to qualify the existing tenants and to make sure that the terms of each commercial lease are at market:

1. Be a Secret Shopper.  Pretend to be a customer and visit the business - in person - and see what your first impression is.
2. Drive the Market Area.  Make a list of your prospective tenants and drive around to see how much competition they have.  Consider how they compare to the tenants you're buying.
   
3. Examine the Tenant File.  During your due diligence period when buying the property you've likely been given copies of the leases to review.  Make sure to ask the seller for copies of the tenant applications, credit reports, and business plans gathered when the space was first leased.  If the seller can't or won't provide these ask why, and give the property transaction extra scrutiny.
4. Examine the Actual Rent Deposits.  Again during your due diligence, the seller will likely give you profit & loss and aging reports showing rent payments received from each tenant.  Make sure to look at the actual dates the rent checks are deposited.  Seeing a report that shows a tenant paying every month is different from seeing that the tenant is paying late every month.
5. Look at Competitive Properties.  Talk to the tenants in neighboring properties and see what opinion they have of the building you're about to buy.

I always like to have my clients do as much of these tasks as possible.

It's not because I'm lazy.  It's because one of the toughest things to do in property management is to educate the property owner about the market.

And the easiest way to get educated is to go out in the field and play detective, instead of sitting behind a desk and doing research on the internet.

Or worst of all, thinking you're smarter than the current owner.  To be blunt, you're probably not.

After all, they're the ones that are getting you to accept each commercial lease as-is and to buy in a down market!

Jeffrey Roark
Property Management Training
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