by Alice Devine
Read, Baby, Read
Up your financial literacy with a subscription to the Wall Street Journal, either old school via paper or online. A column titled “What’s News” organizes “Business & Finance” and “World-Wide” topics on the front page. Supplemental online industry articles and discussions are also available in the Wall Street Journal’s real estate-focused columns.
Request Tenant’s Information
Financial meltdowns underscore what prudent real estate professionals already know: a creditworthy tenant is golden. Assuming there are prospective tenants in the marketplace, a landlord focuses on credit checks and financial statements.
Credit Checks
For a nominal fee, landlords can ask for a prospective tenant’s consent and information to run a credit check, and focus on a tenant’s history of timely payments. Late or insufficient payments to other vendors, even if tenants have paid their rent on time, indicate default tendencies. Companies such as Dun & Bradstreet will provide a credit report and break down that information into late payments, non-payments, vendor type, and so on. It’s a fee well spent. The timing for a credit check depends on your take on the tenant. For example, you might request a credit check for some companies prior to investing space planning dollars, while you might wait until the proposal stage to verify a seemingly robust company. There’s more discussion on the delicate art of timing below.
Check It Out
In addition to online and printed financial analysis resources, organizations such as the Appraisal Institute and Dun & Bradstreet’s customer learning center offer classes and webinars focused on tenant credit analysis.
The Power of Search
In addition to obtaining a formal credit report, you can do your own online search. Fortunately, our information age places public financial information and news reports a click away. News subscription services such as LexisNexis (and similar companies) compile all sorts of media and other information on companies. And your own online search not only allows you to gain valuable information on a company, but may also provide valuable information about the principals, their interests, and peripheral news that can assist you in your leasing efforts.
A Firsthand Visit
Some real estate professionals visit the tenant in its current leased space for a firsthand look at the company’s vibrancy. Personal visits can give you valuable leasing information as you watch an active sales force at work (or not), see deliveries (or not), and hear a bustling office (or not). For example, suppose a representative from a three-person office seeks to lease 5,000 square feet. That should set off warning bells and prompt a realistic discussion of the tenant’s business plan to ensure its business justifies such an expansion. Let the tenant know you’d love to stop by in order to get a sense of the existing office layout to prepare for the space planning meeting. You can do double duty with the visit—look at the office configuration and assess the business’s vitality. It’s all part of conducting some due diligence.
Financial Statements
Trying to assess a tenant’s credit as early as possible—without burdening the prospect—forestalls leasing risks and problems. As a general note, the further your lease negotiations progress, the more pressing the need to review financial information. As with so many aspects of leasing, timing matters. When financials are requested too early, prospective tenants may be alienated before they have developed any relationship with the landlord and property. Asked too late, the landlord and tenant have already invested time and (possibly) money in the transaction, making it difficult to walk away from the deal, even when credit is risky or financials don’t pencil. The following is a rough timing guide of what to ask for when, as tempered by your own instincts, judgment, and company counsel.
In addition, recognize that the burden of providing financial reports varies by company. For example, a publicly held company can readily deliver audited statements while a privately held company may need more time and effort to produce the same information.
When to Ask
During the initial broker contact or touring stage, try to obtain a loose understanding of the tenant’s credit from the broker or tenant. While you might avoid a direct question on credit rating during the tour, use that meeting to scout the tenant’s length of time in business, occupancy length at other buildings, square footage, type of business, and clients. In a hot market with little supply, all bets are off—landlords may require financial statements at the same time as the tour.
Prior to space planning, most landlords request formal financial statements (unless the market is very soft, with tremendous space availability). In the event you proceed with space planning and its associated costs, some landlords ask prospective tenants to indemnify them for space planning expenses if the tenants do not deliver financials later or misrepresent their financial strength. (Refer to chapter 6 on space planning for more discussion.)
At the proposal stage, it’s advisable to have financial statements. In the event that landlords proceed without such statements, they add a contingency clause to the proposal, dependent—among other items—on a review and approval of the tenant’s financials.
It would seem foolhardy to sign a lease without a comprehensive review and approval of the tenant’s financials and creditworthiness. Enough said.
What to Ask
To obtain a rounded look at your prospective tenant’s financial strength, request audited financial statements for the past three years, including a balance sheet, income statement, and cash flow statement. (More on how to interpret these below.)
Contingent Upon Review
Standard proposals to lease typically contain contingency clauses for review and approval of the tenant’s financials, among other items. You should confer with your own legal counsel, but many leasing representatives use some version of this statement:
This proposal represents a preliminary outline of proposed business terms, and both parties understand and agree that no binding contract shall exist until the lease agreement has been fully executed by your client and us. This proposal shall not be considered a reservation of the premises and is subject to prior lease of all or any portion of the premises.
Upon receipt of the financials, you can send a follow-up letter to the prospective tenant confirming you have received the financials and that the decision to enter into a lease agreement will be based on that information. That way, there’s some recourse should the tenant misrepresent its financial strength or history. The last thing you want is to be saddled with a tenant that moves in and defaults on the lease terms. Case law, particularly in pro-tenant states such as California, makes remedy or eviction an arduous process.
Next, confirm that the financials you receive match the signatory entity on the lease contract. In markets rife with start-up companies, you may be given financial information for a parent company instead of the subsidiary, or for a separate company that is an investor, but not an owner, on the lease. Brokers sometimes fail to differentiate between the entities, so the landlord needs to confirm that the lease signature block matches the entity represented on the financial statements.
Keep It Contingent
Standard proposals to lease typically contain contingency clauses for review and approval of the tenant’s financials.
I once lost a tenant to a competitor’s building. I ruminated. I lost sleep. The tenant was a start-up, bankrolled by a major communications company. Fast-forward a few months to when the start-up defaulted at the competitor’s building. The other landlord pursued legal remedies. Whoops. It turned out the big daddy communications firm was only an investor with no legal responsibility for the start-up, including the lease contract. The incident taught me a valuable lesson: absent another guarantor, the entity that signs the lease is responsible for the rent. That seems obvious, but it’s easy to confuse players in the hurly-burly of a deal. From that point forward, I made sure our lease signature bloc
ks exactly matched the entity that had provided the financials (on which we based the deal). Sometimes, the best deal is the one you don’t do.
Foreign-Owned Entities
In an increasingly global market, you may lease to foreign-owned companies. These situations pose an added challenge when verifying creditworthiness and understanding a company’s ownership structure. Some landlords require that the prospective tenant have enough United States–based financial accounts and assets to ensure rent payment and for collateral in the event the tenant defaults. The Commercial Lease Law Insider, an industry newsletter that focuses on legal lease issues, advises that any lease guarantor be US based.2 Presumably any prospective tenant whose financials lead the landlord to request a guaranty is riskier, and the landlord needs to ensure reasonable access to funds.
Book Club, Part 2
John A. Tracy’s How to Read a Financial Report is a short, sweet, and highly useful book that focuses on financial statement analysis.
Evaluate Financial Statements: The Good, the Bad, and the Ugly
While you rely on accountants and analysts to dissect the financial statements used to evaluate a tenant’s credit, you should also understand reports enough to make informed leasing decisions and justify the deal offered.
Audited, Reviewed, and Compiled
Traditional financial information is conveyed via an income statement, cash flow statement, and balance sheet, and supplemented with a credit report. In addition to having an industry standard language and format, these reports—if prepared by a CPA—adhere to GAAP (generally accepted accounting principles). The uniformity assures us that a certified professional has examined the reports and that the information is conveyed in a consistent manner across reports.
According to New York–based accountants Grassi & Co., “Since the landscape is changing, it is important to understand the significant differences between these levels of services—Compilation, Review and Audit.”
There are varying levels of scrutiny and rigor applied to the production of financial statements. According to New York–based accountants Grassi & Co., “Since the landscape is changing, it is important to understand the significant differences between these levels of services–Compilation, Review and Audit.”3 For leasing purposes, audited reports are optimal because of the higher level of scrutiny and approval. Then, in order of descending preference, reviewed and compiled reports might be acceptable. In-house statements are just that, and are therefore less desirable because of the lack of an objective, third-party, qualified review. As a note, securities laws demand that all publicly held companies provide annual audited financial statements.
So what type of reports should you request from your prospective tenant? Remember the acronym BIC: balance sheet, income statement, and cash flow statement. Financial statements reflecting the past three years provide a good overview. Together, these reports offer a snapshot of current finances as well as a longer-term economic view of the company.
Do You Know These Accounting Terms?
GAAP: generally accepted accounting principles
CPA: certified public accountant
Audited statements: the highest level of assurance by a CPA that financials are accurate
Reviewed: a middle level of scrutiny, limited assurance by a CPA that financials are accurate
Compiled: assembled financial statements, CPA expresses no assurance
Remember BIC
Ask prospective tenants for Balance sheets, Income statements, and Cash flow statements for the past three years.
The Balance Sheet
The balance sheet profiles a business’s financial strength at a specific moment in time, usually at the close of an accounting period. It details material and intangible items the business owns (assets) and money the business owes—credit to creditors (liabilities) and owners (shareholders’ equity). Balance sheets contain standard categories of assets, liabilities, and net worth.
Assets include cash, merchandise inventory, land and buildings, equipment, machinery, furniture, patents, trademarks, and so on, as well as money due from individuals or other businesses (accounts or notes receivable).
Liabilities are funds acquired for a business via loans or the sale of property or services to the business on credit. Creditors acquire promissory notes to be paid at a designated future date but do not own any portion of the business. Other liabilities, such as litigation or environmental issues, may not be visible.
Shareholders’ net worth (or capital) is money invested into a business by the owners for the business’s use.
The Income Statement
The second primary report included in a company’s financial statement is the statement of income, a measurement of a company’s sales, expenses, and net income or loss over a specific period of time. Income statements are prepared at regular intervals to show the results of operating during those accounting periods. It follows GAAP and contains specific revenue and expense categories regardless of the nature of the business.
The Cash Flow Statement
The cash flow statement reveals where cash comes from and how it is used for a given period of time. Leasing personnel use this statement to identify items such as deficiencies in collecting receivables, unrealistic trade credit, or loan repayment schedules. The statement also identifies surplus that can be invested on a short-term basis or used to reduce debt.
The cash flow statement also reveals how much cash has been internally generated from sales and the collection of accounts receivable and how much has been borrowed from external sources. External sources may include borrowing from financial institutions as well as ownership investment in the business. The uses of cash generally fall into three separate categories: distributions (dividends) to owners, capital expenditures, and reduction of debt.
Analyzing Ratios
Operating ratios are benchmarking tools that allow us to see how the company under review stacks up against other companies in similar lines of business. Over time, ratios tell a longitudinal story with trends. These ratios inform leasing decisions as you assess risk and decide how much capital to invest in a deal.
Operating ratios are benchmarking tools that allow us to see how the company under review stacks up against other companies in similar lines of business.
While ratios vary from industry to industry as well as geographically, landlords want assurance that the tenant can pay rent. To that end, landlords examine the rent coverage ratio, that is, how much the rent (or projected rent) is expected to cost the tenant relative to its income and other obligations.
Summary of the Tenant’s Financial Health
After running a credit check and obtaining financial reports and reviewing them, most leasing departments prepare a financial summary of the deal. A synopsis, it covers the tenant’s financial strength, credit history, and type of business, and highlights any areas of financial weakness, if applicable. The summary also includes all the proposed economic points of the deal, including the important net effective rent (which takes into consideration free rent and capital lease investments). Leasing representatives circulate the summary to the building ownership prior to giving the prospective tenant a lease proposal so that any landlord objections or concerns may be addressed prior to the lease negotiation and signature.
Protect Your Downside: Defensive Leasing
What if there are some riskier aspects discovered in the tenant’s financial reports, but other factors, such as a tough market or undesirable space, compel you to lease? Leasing personnel can take a protective stance by requiring increased security deposits, letters of credit, guaranties, and prepaid rent to shore up the risk of a tenant with less than stellar financials.
Security Deposit
First, and perhaps most simply, leasing representatives can ask for a more substantial security deposit. This gives the landlord instant access to cash in the event of a tenant defau
lt. And companies such as funded start-up firms can be flush with cash but have little credit history. For the tenant who protests locking up a six-month security deposit, landlords sometimes agree to decrease the amount of a required security deposit over time as the tenant fulfills its lease obligation and builds a track record of timely rent payment.
Letter of Credit
Next, leasing representatives may ask for an irrevocable letter of credit from the tenant’s bank so the landlord can collect rent immediately in the event of default. One step removed from instant cash (i.e., the security deposit), these letters do give the landlord a fairly easy solution in the case of default. As added solace, a bank’s willingness to grant such a letter is a positive indication of the prospective tenant’s creditworthiness.
I once took a memorable elevator ride with the founder and president of my firm, Bill Wilson. In between the lobby and the twentieth floor, Bill and I discussed the terms on the table for a prospective tenant. As he stepped from the elevator, Bill announced, “Credit is king,” meaning he’d do a deal all day long with a creditworthy tenant and a lower rental rate as opposed to a risker tenant at a higher rental rate. Later, after lowering the rent a bit, I landed the tenant. Over the next years as the tenant expanded and extended its lease, I remembered Bill’s excellent advice. Moreover, when the booming real estate market slowed and floundering tenants fled their leases, our buildings remained relatively full with solvent tenants able to write a monthly rent check.