Commercial landlords are feeling the pressure in the current economy. With the stock market getting battered, the highest interest rate raises in 30+ years and general malaise from inflation we’ve got “issues” as a wise man once said. This is on the heels of watching landlords recover from the massive tenant default rates from the COVID crisis, understandably, they are working hard to protect their asset values. While there is no one silver bullet that can solve all of a landlord’s risks and potential issues, there are a few steps that can be taken to help protect asset value and mitigate tenant default risk in any market, but especially in times of economic uncertainty.
As the industry leader in tenant default protection, our team at Otso hears a lot of these concerns from our customers every day. In this blog post, we will share ways landlords can maximize protection and value for their assets amidst our current environment.
Comprehensive Reporting of Tenant Financials
One way that they are doing this is by requiring more stringent qualifications from potential tenants. Most landlords do not have the tenant underwriting team resources like a REIT or large ownership group. Business credit reports, tax returns and other sources that are often unaudited (like projections) do not suffice in understanding the true financial health of a business. As a result, these landlords are turning to tenant screening services that provide in-depth analysis of a tenant’s financials. This includes both a review of their historical performance as well as an assessment of their current financial situation. The goal is to identify any potential red flags that could indicate future default risk.
Making a mistake with a tenant means writing an enormous check for deal costs not once, but twice and in a shorter amount of time. This scenario kills returns and affects investor sentiment greatly.
At Otso, we have saved numerous landlord customers from doing deals with businesses that we determined as high probability for future default risk. This type of analysis can be critical in understanding a tenant’s ability to weather an economic downturn. It can also help landlords make informed decisions about which tenants to approve for their properties.
Collect More Collateral
We’d all love more cash on the books. However, the reality is that most tenants (especially ones well represented) will resist locking up cash in a deposit account for years on end, at no interest. Buildings are not rocket science, they need rent to thrive. So deals are made more often than not. This reality leaves landlords often severely under-collateralized in the event of a default.
We coined a new term “collateralization ratio” to help landlords estimate what they have on hand to stem the tide if there is an issue with tenants. We surveyed landlords on this topic and our results were staggering, most landlords had a ratio of less than .15 in the bank compared to deal costs they spent to get a space leased. This means for every $100,000 in deal costs (most often TI and commissions) they were collecting less than $15,000 in cash. Yep, most landlords would be $85,000 upside down if those costs did not have time to full amortize over the term of the lease.
With Otso, these landlords are now seeing a healthy collateral ratio, .5+ on average. This means they are carrying a minimum of $50,000 for every $100,000 spent. Otso allows for this on every deal, so at the building value, it’s massively impactful. For example, landlords in some markets are collecting 4-6 months of rent equivalent in a lease deposit instead of collecting one to two months. A typical landlord with Otso gains on average 300% more than they typically would collect from a tenant in security deposit or letters of credit.
Additionally, as we see landlords invest more in tenant improvement allowance to add value to their assets and attract tenants, they are also ensuring those costs are protected through Otso’s insurance offering.
Lastly, we are seeing a regional trend away from personal guarantees. Some states where it is standard that landlords require a personal guarantee have not changed yet, but will. Personal guarantees have varying degrees of success for landlords. In fact, many states find them to be less than friendly to landlords when it comes time to enforce them in the event of an issue. Couple this with the fact that every tenant absolutely hates them – personal guarantees end up being more of a hindrance than a help.
Another way landlords are protecting their asset value is by diversifying their tenant base. By having a tenant mix that consists of different types of businesses, landlords can mitigate the risk of tenant default. For example, if a retail center has one tenant that goes out of business, the other tenants in the shopping center will most likely be able to stay open and continue paying rent. This type of diversification can protect landlords from taking too big of a hit if one tenant defaults.
Landlords are leveraging third-party companies to stay updated on the status of their rent roll. For example, check out this Tenant Tracker (LINK THIS) which offers the following services for as little as $20 per month. 1) Predictive intelligence of a property’s rent roll helping landlords anticipate tenant issues ahead of time. 2) Real-time notifications for any change in a tenant’s entity standing or financial health. and 3) Recommendations for improving an asset’s value and protection.
Improved Contract Terms and Conditions
Another way commercial landlords are protecting their asset value is by improving the terms and conditions in their lease agreements. In particular, they are focusing on clauses that relate to tenant default and tenant improvement allowances. By doing this, landlords are able to minimize their financial exposure in the event that a tenant does default on their lease agreement. They are also increasing rents and offering shorter lease terms. This will help to ensure that they can recover their costs if a tenant does default on their lease agreement.
While the current economy is unstable, these steps are helping landlords mitigate the risk of tenant default and maintain a healthy portfolio despite the ups and downs of the market. While these steps may not completely eliminate the risk of tenant default, they can help to mitigate it. And, when combined with a well-diversified portfolio, commercial landlords can weather any economic storm and come out ahead in the end.
We recently announced our partnership with commercial real estate’s powerhouse leader in tenant and market due diligence, Megalytics. Commercial landlords can now access robust data-driven tools for identifying quality tenants while gaining protection against every instance of tenant default. With our partnership, we are able to introduce the first comprehensive package for continuous monitoring of tenant financial health and additional protection on every lease.
What other strategies do you think commercial landlords should consider? Share your thoughts in the comments below!