CRE Midwest

It’s a tenant’s market, but…

To reduce risk, tenants should make sure developers and landlords have the financial strength to keep their promises.

By Steven W. Schnur

Senior Vice President - Duke Realty

If leasing due diligence is like passing through airport security, one could say that tenants usually endure the equivalent of full-body scans and pat-downs while landlords sail through the “fast lane.”

Historically, prospective office and industrial tenants have undergone close scrutiny from developers and landlords to assess their creditworthiness. Yet would-be tenants have usually been more concerned with lease rates, operating expenses, tenant improvement (TI) allowances and other issues, often paying scant attention to the financial position – or even the identity – of their future landlords.

Today, however, with many properties struggling financially, there is heightened risk that owners will fail to perform – and that can be disastrous for tenants. That is why prudent tenants should take a much closer look at the backgrounds and capital positions of potential landlords and their buildings.

It’s a tenant’s market, but…

Attractive lease terms can present tremendous opportunities for businesses. Prospective tenants can potentially lock in favorable terms that will significantly reduce their overhead costs for years to come.

Though large rent abatements and TI allowances can be tempting, landlords may be offering these incentives for other reasons. Perhaps the owners are struggling financially and are desperate to lease space. Deep discounts, especially as part of long-term leases, may be indicative of a landlord’s inability to obtain financing for new developments or generate sufficient operating income to refinance or service the debt on existing buildings.

When the commercial real estate business was booming in 2004-07, a general assumption prevailed that developers and landlords would meet their financial obligations. But, as the recent downturn has demonstrated, commercial real estate can carry unexpected risks. That’s why it’s important to scrutinize the financial positions ofpotential and existing landlords.

The U.S. economy is strengthening, and conditions are improving, but the commercial real estate business remains challenging. Though the month-over-month growth in the CMBS delinquency rate has slowed, March 2011 delinquencies reached their highest point ever, 9.42 percent, according to the Trepp data service.

Trouble for tenants

If landlords are under financial pressure, they might not be able to raise the capital needed to meet their obligations, which can cause significant difficulties for the tenants.

For example, let’s say a manufacturer needs to ramp up production to serve a major new client. To facilitate that, the manufacturer depends on being able to move into a newly constructed warehouse and distribution center by a certain date. But if the developer fails to obtain financing and construction is delayed or cancelled, the manufacturer’s delivery schedule, reputation and very existence could be threatened.

In the case of an existing building, tenants who were recruited or retained by attractive rents and generous TIs might find that the landlord is unable to meet its debt service for that building. Or perhaps that property is performing, but the landlord is being squeezed by other properties in its portfolio. In either case, those financial pressures can result in deferred maintenance and repairs, TI funding delays, unpaid commissions and fees – all of which can have a negative impact on the corporate image and operations of the tenants.

Before the financial crisis and the Great Recession, it seemed as if financing was within reach for nearly any commercial real estate project. Whether the capital was used for new development, renovations, TIs or operating expenses, credit was readily available.

But that spigot closed in 2008 and today’s underwriting standards remain much tougher – nor is that likely to change any time soon, as financiers remain cautious about their lending practices.

Thus, prospective tenants must recognize that these are extraordinary times in commercial real estate and the capital markets. That presents extraordinary opportunities – and risks.

How tenants can reduce risk

Here are some ways prospective tenants can reduce leasing risk:

1.) Know the developer or landlord. Who owns, or will own, the building? What is their track record with respect to similar projects? How much experience do they have with this specific product type? Would you normally consider this developer or landlord if they weren’t offering such attractive lease terms?

2.) Dig into their finances. Conduct careful due diligence into the overall financial position of the developer or landlord, as well as the status of the specific building under consideration. What kind of access to capital do they have? Is financing in place for a new development? Is the mortgage current or up for renewal for an existing building? Who is the lender? What is the lender’s financial position and current strategy with respect to commercial real estate?

3.) Do a reality check with the marketplace. What are current and projected market conditions with respect to vacancy rates, lease rates, TI allowances and other lease terms? How do the terms being offered by your potential developer or landlord compare? Are they significantly below market and, if so, will the net operating income (NOI) be enough to support a well-managed, well-maintained building?

4.) Understand the specific lease terms. What penalties are in place if a landlord fails to perform? Do tenants have the right to terminate leases?  What protections do tenants have for quiet enjoyment if a lender forecloses?

Proceed with caution

It is a tenants’ market. There are outstanding values available to businesses that can identify available space that is in alignment with their business objectives. But today’s commercial real estate market carries risk. Deals could turn unfavorable,  even disastrous,  for tenants if developers or landlords fail to perform.

Historically, landlords have held tenants to high financial standards. Tenants can more safely seize opportunities and mitigate risks by holding landlords to similar standards.

Steven W. Schnur is a Senior Vice President with Duke Realty and heads the firm’s Chicago office. For more information, please visit the company’s website at www.dukerealty.com.