What’s The Best Type Of Tenant?

With so many fluctuations in today’s market, securing the right tenant has become crucial—they will be a source of cash flow for your investment and losing one could lead to short-term or long-term losses. This means you’ll want to carry out solid research before presenting any leases. You’ll also want to make sure the terms are set up in a way that provides protection for your interests.

That said, the perception that this type of relationship is a “one-way street,” in which the tenants exist to provide rent for landlords and nothing more, is largely a concept of the past. Today, regardless of whether you are dealing with multifamily, office, or retail, you’ll want to consider what you as a landlord can offer renters. When done well, you can help tenants on their own success paths, which can bring benefits for everyone involved in the investment.

Carrying out Diligence

Before taking on a tenant, you’ll want to know, first and foremost, with whom you are dealing. For multifamily, this could be as simple as researching their history and carrying out a credit check. You can follow up on references too. Of course, there are countless nightmare situations which involve tenants who have a bad track record and lack the financial wherewithal to make payments. Taking steps to vet individuals before offering a lease will help you avoid those headaches later. Keep in mind that each state has rules regarding what you can and cannot do when verifying tenants. Speak with a good rental broker for advice on measures you’re allowed to take and to ensure you’re following the legal guidelines.

For office and retail investments, finding the right tenant can be even more important since the leases are typically longer-term. Retail spaces might have three- to five-year leases. It’s common for office leases to run 5 years, 10 years, or even more. In contrast, for multifamily the length of the lease might be only a year. You could also have fewer office and retail tenants than multifamily (or just one).

The Right Tenant Lease Terms

For office and retail, part of the negotiation process often involves how the tenant will initially take the space. There may be specific needs that the business has which require renovations or construction work. You’ll want to agree on how the building will be delivered. There could be tenant improvement allowances, which are given by the owner to help the tenant cover expenses related to moving into the space.

For this reason, you’ll want to do all that you can to ensure you’re bringing on a creditworthy tenant. You can speak to past landlords to verify that the tenant is financially capable and a good steward of the space. To know what’s commonly expected in your market, work with a local leasing broker who is familiar with the customs. Also bring in real estate counsel to help you get the best terms and protect your interests.

When Larry Haber, the managing partner of the Commercial Real Estate Department of the bi-coastal firm Abrams Garfinkel Margolis Bergson, joined an episode of my podcast, “The Insider’s Edge to Real Estate Investing,” he stressed the importance of legal considerations when setting up a lease. Be aware of the “good guy clause,” which states that a tenant who is current on the lease has the option of giving back the keys and walking away, provided the place is in good condition.

Financials for Office and Retail

Credit tenants have sufficient guarantees and financial backing, and are often household names or national chains. You can find credit ratings at places like Moody’s or S&P. Avison Young also has Net Lease Advisor, where you can check the average cap rate associated with a tenant along with cap rate trends. As of August 2023, Sonic was listed with a credit rating of B2 by Moody’s, B+ by S&P, and a cap rate of 5.34%. It had a cap rate of 6.10% in 2021 and 5.42% in 2022. CVS had an average cap rate of 4.8%, shifting from 5.70% in 2021 to in 5.40% 2022. Its S&P rating was BBB and Moody’s ranked it Baa2.

Smaller, non credit tenants will typically have a higher cap rate, and they will often pay higher rents to adjust for that. They may be asked for more security too, since they lack a corporate guarantee. If you’re planning to resell the asset, the tenant and associated cap rate could play a significant role. A bank might be looking for the lower risk that typically comes with a credit tenant that has a corporate guarantee.

Don’t Overlook Smaller Players

While some sources will view a national tenant as being more creditworthy than others, I always like to point out that a mom and pop tenant can be just as valuable. Many of these mom and pop tenants have held their business for a long time and maintain great pride in their space. They will often do everything possible to make the space work and carry on, even if there’s a downturn. This was especially true in certain areas post Covid, when we saw many national tenants close stores and make large scale exits.

With a changing market, the relationships you cultivate with tenants will continue to have utmost importance. As you set up a lease, understand what’s in the fine print, especially if you’re making a significant financial investment initially. When carried out well, you can have a long-term tenant who will ultimately become your partner in the building and investment.

James Nelson | Forbes.com