How Inflated Rents are Risking CRE Purchase

David Cohn
Apr 6, 2023
CRE in Inflation

Before underwriting a potential commercial real estate (CRE) offer, it’s essential to determine the current rent that tenants are paying. If you find out that the biggest tenant pays above-market rates, then you might be looking at a risky situation.

Sky-high rents paid by anchor tenants are unsustainable.

Before committing to a property, weigh the risk associated with having an anchor tenant whose lease rate is higher than market value.

Think about it: If the tenant accounts for a large portion of that property's total income, things can quickly become costly when their contract ends, and they negotiate a more desirable rate.

As the landlord, you will be confronted with a tough choice when the inevitable occurs, and an anchor tenant requests an adjustment closer to the market rate.

You can concede and sign a new lease, accepting diminished revenue.

The other option is to search for a replacement tenant. It can be challenging to find a new tenant that is the right fit for the unit's configuration, especially if it's definite.

Furthermore, a new tenant will only be willing to pay up-market rates. This issue can be particularly challenging when the anchor tenant is in a business segment facing a long-term downward trend.

Again, take the movie theater industry as an example. The pandemic caused significant losses in this line of business, and it has yet to recover fully.

The problem is that tenants in this segment were often leasing space at higher than market rates because landlords held all the power before COVID-19 changed everything.

In some cases, landlords even agreed to contribute towards costly buildouts for these tenants in exchange for higher rents and multi-year leases.

If a theater tenant wanted to renegotiate their contract, it would be difficult for the landlord; there are few replacement tenants in this industry, and any incoming tenant would face similar economic hardships.

The last option is to renovate the space and make it suitable for a different tenant.

This often requires hefty funding from the landlord, and it's only possible to predict if this is worth the money once a new lease has been agreed upon.

Due diligence is more important than ever.

This is why it's critical to do your research before investing. If the property has an anchor tenant paying above-market rents, it's wise to factor a discount on your offer price for the potential drop in rental revenue once the current lease expires.

Failing to adjust this offer price could mean watching your investment quickly deplete as soon as rent drops.

How to evaluate a lease

Analyze the rent roll carefully and watch out for any signs of inflated rents. Begin your review by investigating the rents paid by significant occupants.

Furthermore, reach out and have a dialogue with that anchor tenant.

This is an ideal opportunity to get their take on their existing lease agreement and gain insights regarding their future activities/plans.

Thoroughly examine the lease contract when investing in a property. After all, this document represents the gross income of the CRE asset.

Therefore, you want the lease to have unambiguous language that limits misinterpretation.

You also want to check the type and frequency of rent raises and compare actual rents versus market rates.

Is the lease drafted using precise and unambiguous language to avoid misunderstandings that may result from ambiguity?

Read through each clause of the document thoroughly and ask your lawyer to do so for an additional layer of assurance.

For example, make sure that it's clear (1) what duties you are responsible for as the landlord, (2) what rental increases were settled upon and when they go into effect, and (3) under what conditions a tenant may terminate their lease.

Look for fair rent

Inflated rents may make the returns on a CRE investment look attractive, but beware—those returns will inevitably drop when it's time to renew contracts, mainly if comparable CRE is more affordable elsewhere.

This decrease in rental earnings will significantly reduce the resale value of your investment.

The actual yield may even be lower than what you might get from other investment opportunities.

Thus, it is essential to read the lease carefully, determine the annual rental rates per square foot, and then compare those figures with current market prices.

In many cases, it's better to buy a property that is charging fair rent, to begin with.

Other factors to look at

Doing your diligence will assure you that it is necessary for a sound decision-making process. Aside from fair rent, several other factors should be considered before buying a CRE asset.

  • Diversification - Be careful about buying commercial properties that cannot be readily re-let for various uses or by several tenants. These are considered to be higher-risk investments.

Given the pandemic's market changes, two categories are considered safer than others: medical centers and industrial complexes. There is a multitude of potential occupants available in these two segments.These properties are versatile, too. For example, a 500 sqm industrial property can be rented out to many other types of tenants, including electrical engineering companies, kitchen door manufacturers, solar panel distributors, tile/flooring businesses, incredible room storage businesses, furniture storage companies, and even online ventures that require storage.

  • The strength of the location - Capital cities are the ideal choice for commercial real estate because of their increased customer base, high foot traffic, and well-developed infrastructure. These assets surrounding it are necessary for a property to be significantly riskier. These fundamentals remain strong in capital cities.
  • Always consider the local demographics of an area before investing, too. This includes examining factors such as employment rate and median income level.
  • After this, conduct a legal analysis and determine if there are any potential problems regarding restrictions, easements, and encroachments. These factors can significantly affect the overall value of the CRE property because they can potentially restrict what you're allowed to do with the space later on. So make sure you're aware of them.
  • Market conditions - The current market climate has caused a strain on retailers, so many analysts advise against purchasing a property with a retail tenant. Also, be careful of properties in areas with high vacancy rates and known supply chain issues.
  • The quality of the tenant - Be sure to thoroughly investigate your prospective tenant's business model and financial stability. This includes looking at their debt-to-equity ratios, operating margins, and the number of stores they use, examining their management team's security, and forecasting future market trends for the industry sector they operate in. Of course, check their credit rating, too.
  • If the tenant is a publicly-listed company, you can quickly check their credit rating online using Moody's,, and other websites.

For private tenants, request and study critical documents such as their credit report (Equifax Small Business Enterprise, Accurint Business, ClientChecker, etc.), their business plan, their recent sales history, and their tax returns and annual financial reports.If you need assistance, bring in a tenant underwriting service.

Such experts can help you analyze this information to decide if the potential tenant—and the property itself—is a good fit for your business goals.

Looking for signs of inflated rent is one the most critical parts of the due diligence process in purchasing a CRE property because it is a significant risk to the investment's financial success.

In rare cases, the due diligence process may uncover the opposite situation: an anchor tenant paying below-market rates.

As the landlord (post-acquisition), this means that you can increase the rent when the lease expires and a new one is negotiated, potentially increasing the property's NOI and contributing to equity accretion and increased cash flow. But assume that this situation is rare.

In CRE, the most successful investors are prudent in analyzing lease agreements and looking for red flags associated with inflated rent.

They underwrite deals based on the amount they realistically rent each unit for—not necessarily what the current tenants are paying.

You can avoid the unpleasant surprise of a significant revenue reduction later on by taking time to do some analysis.

You also want to ensure that you're working with experts in your investment team.

A highly-experienced CRE financing placement and advisory firm can offer value throughout acquiring a commercial property. Contact Capital Investors Direct.