Evaluating the Value of Tenant Credit to a Landlord based on the Market

The value of a tenant’s credit to a landlord is largely dependent on the global, national, and local marketplaces. In stronger markets, the value of a credit tenant will diminish relative to weaker markets. This is easy to see if you consider what constitutes risk in ownership of income properties. Vacancy, lease-up costs, eviction costs are all well known risks protected against by creditworthiness.

Vacancy and lease-up costs are less likely in strong markets, and therefore any hedge to protect against them will be devalued. In weak markets with higher vacancy and lease-up costs, the opposite will take place.

However, the qualitative approach above does not provide a framework to determine monetary value, only that values changed depending on the marketplace. The determination of monetary value requires quantifying the worth of credit based on its affect to the pricing terms of a transaction.

In my experience, there is limited literature online which reviews how to quantify the worth of credit in commercial real estate transactions. I am unaware of any standard process by which all tenants and landlords approach this issue internally. Whatever process is used, it must be recognizable and relatively easy to understand for all parties involved. Otherwise, it will be difficult to gain the consensus necessary to negotiate any value of creditworthiness effectively.

Tenant Credit Value via the Direct Comparison Approach

One approach to quantifying the value of tenant credit is the direct comparison approach. Tenant A leases a 100,000 square foot single tenant industrial building for $10.00 per square foot. Tenant B leases a comparable building in the same market for $11.00 per square foot. Adjusting for differences such as length of term, tenant improvements, and amenities it is determined Tenant A’s creditworthiness is worth $0.50 per square foot per year.

Despite appearing to be a simple approach to value, it is exceedingly difficult to establish that tenant credit value is the adjusted difference between two comparable lease transactions. First, there is determining how much adjustment is required for factors such as length of term, rent abatement, tenant improvements, and amenity differences.

Furthermore, there are other considerations outside of the transaction and physical differences. What about the skill of the negotiators involved, the appetite for coupon rates versus effective rates in one or both parties, the requirements of the landlord’s credit committee, etc.? The direct comparison approach, if used to determine the value of tenant creditworthiness, would likely result in more complexity in establishing a value and more challenges in finding consensus among interested parties.

Tenant Credit Value via Vacancy and Credit Loss

Therefore, a better approach to quantifying the value of tenant credit in a given market is to use standard underwriting methods which are familiar to landlords. In particular, the vacancy and credit loss percentage, used to adjust gross scheduled income for the overall risk of vacancy and credit loss in the market, can be adjusted according to the perceived risk profile of the tenant’s credit.

Any adjustment in the vacancy and credit loss percentage will impact the landlord’s anticipated net operating income, creating an opportunity to calculate comparative net operating incomes depending on tenant and market creditworthiness. As the following example will outline, it is not difficult to proforma rents based upon comparative tenant credit if there is an understanding of market rents and vacancy factors.

Assumptions

-Two tenants interested in leasing a 100,000 rentable square foot single tenant industrial property (“Premises”)

-Tenant 1 has 0% chance of default (i.e. the U.S. Government)

-Tenant 2 has average credit for the market with a 5% vacancy rate

-Market rents for the property are $10.00 per square foot annually

-Operating expenses are $2.00 per square foot annually

Tenant 1 anticipated net operating income for year 1 can be calculated as follows:

Scheduled Gross Income: $1,200,000
-Vacancy Factor:$0 (0% chance of vacancy)
+Other Income: $0
=Effective Gross Income: $1,200,000
-Operating Expenses: $200,000
=Net Operating Income: $1,000,000

Tenant 2 anticipated net operating income for year 1 can be calculated as follows:

Scheduled Gross Income: $1,200,000
-Vacancy Factor: $60,000 (5% chance of vacancy)
+Other Income: $0
=Effective Gross Income: $1,140,000
-Operating Expenses: $200,000
=Net Operating Income: $940,000

Based on our example above, Tenant 1 could argue that it should pay $60,000 less per year than the average credit tenant or $0.60 per rentable square foot per year based on 100,000 rentable square feet. In this example, Tenant 1’s credit value is $60,000 per year compared to the market.

However, in a strong landlord market with very limited market vacancy, such as 100,000 square foot industrial buildings in Southern California, the vacancy rate for comparable properties will be lower than 5% and likely closer to 0%. This lower market vacancy will reduce the comparative advantage of Tenant 1’s creditworthiness, thus reducing its credit value to the landlord.

Lastly, tenant credit is not usually equivalent to the U.S. Government and may not be average for a given marketplace either. Therefore, it is likely when two parties try to quantify the value of tenant credit, there will be a range of value due to variances in the vacancy factor used in the calculation of the net operating income.

Tenant Credit Value via Increase in Property Value

Another strategy for determining the value of a tenant’s creditworthiness to a landlord is through an increase in property value. Although considerably less precise than the adjustment of vacancy and credit loss, comparative sales of similar properties leased by credit tenants versus those leased by non-credit tenants can provide indications of how much value creditworthiness can add to a property.

For example, if comparable investment sales in a certain market indicate that investors will pay 50 basis points more for a property leased to a credit tenant than they will for a comparable property leased to a non-credit tenant, then the value of the tenant’s credit on the purchase price can be calculated using several assumptions as follows:

Two comparable 100,000 RSF buildings
Leased for similar terms at market rate of $5.00 / SF NNN

Credit Tenant
NOI = $500,000
Market cap = 5%
Income approach to value = $10,000,000

Non-Credit Tenant
NOI = $500,000
Market cap = 5.5%
Income approach to value = $9,090,909

Additional Property Value created by Credit Tenant
$10,000,000 - $9,090,909 = $909,091

Calculate Appropriate Reduction in Credit Tenant NOI
Market cap = 5%
Income approach to value from Non-Credit Tenant = $9,090,909
Adjusted NOI = $454,545


Based on the example above, a credit tenant’s value to a Landlord could equate to a $45,455 in rental value per year.

The above approaches are just three examples of ways to determine the value of a tenant’s credit based on the market. In the next few weeks I will review other considerations in determining tenant credit value such as property type, debt, and ownership profile.