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.
Before committing to a property, weigh the risk of having an anchor tenant whose lease rate exceeds the 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 fits the unit's configuration, especially if it's definite. Furthermore, a new tenant won't be willing to pay above-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.
Unfortunately, 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.
This is why it's critical to do your research before investing. For example, 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.
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 commercial real estate 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 resulting 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.
(3) under what conditions a tenant may terminate their lease.
Inflated rents may make the returns on a commercial real estate investment look attractive, but beware. Those returns will inevitably drop when renewing 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 that 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.
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.
Given the market changes brought on by the pandemic, 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, cool room storage businesses, furniture storage companies, and even online ventures that require storage.
Looking for signs of inflated rent is an essential part 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.
Then, as the landlord (post-acquisition), 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 don't assume that this situation is familiar.
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 by taking time to analyze.
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 while acquiring a commercial property. Contact Capital Investors Direct.
