How to Manage Tenant Credit Risk

As a commercial real estate owner, you're familiar with risk. You'll need to take some risks for a return on your investment, and one of the most significant risks that you'll have to handle with care is tenant creditworthiness. Making a profit on your leased property is based on the essential premise that your tenants will regularly pay their rent. If a tenant falls behind on rent, this can threaten your ability to pay the mortgage on your property and keep up with maintenance costs.

Here are some things to consider:

  • What makes a tenant’s credit strong?
  • Long-term national tenants present less risk.
  • Short-term, local/small business tenants are riskier.
  • Tips on managing higher risk tenants with lease abstracts
  • Hire a property manager with experience

What makes a tenant’s credit strong?

A tenant's creditworthiness, or how suitable they are with financial credit, is based on several factors. Number one is how reliable the tenant has been at paying back borrowed money in the past.

There are also a few "soft" factors that can affect a tenant's rating. More prominent, public companies usually already have a credit rating which will likely come from companies like Standard & Poor's or Moody's, some of the largest financial institutions in the country.

If a prospective tenant is a private company—much more likely for a smaller, local business—they may not have an easily defined rating.

A key to look for would be a company with a "shadow rating" from a bank. There might be different criteria for these ratings, so you'll have to use your judgment. Some measures generally used to help private companies calculate their credit rating include the size and age of the business, the type of business, and whether it's local or international.

Long-term national tenants present less risk

Tenants looking to sign a longer lease usually have more cash on hand and have been around longer—they're planning for the longer term. Having tenants like these can give you stability as a property owner. They've typically seen more ups and downs in the market and are more likely to be resilient if and when future economic downturns present themselves.

Even with these established tenants, you still need to take responsibility to know the market you're in so you can help your tenants help you.

So—where are you in the market? You could be anywhere between:

  • Recovery
  • Expansion
  • Hyper supply
  • Recession

Each is distinguishable by diverse investor behaviors and has an impact on market forces as well as the price of commercial properties.

Short-term, local/small business tenants are riskier

Local and small businesses might be riskier, but that's not to say they should be avoided as tenants entirely. For smaller companies, consider what market they're in and if they might have an upside or if they're trying to break into a tougher sector. Grocery stores and service-providing businesses are easier to get off the ground than clothing or specialty goods shops.

Tips on managing higher risk tenants with lease abstracts

If you are considering tenants whose credit makes them a bit riskier, consider creating a "lease abstract" for each tenant on your property. This is precisely what it sounds like: An abstract or summary that gives a short and sweet description of the length of the lease, payment installments, and anything tenants or their guests are not allowed to do in the building. This abstract might also include when and why, if necessary, any rent increases should be expected from your end.

Hire a property manager with experience

If you are planning on hiring a company to manage the day-to-day operations of your property, plan on hiring management that has experience with the variety of tenants you're aiming to have. Property managers can create individual relationships with each tenant, run operating budgets, and monitor the rates on each property's leases.

Tenants with lower credit might need a bit of extra help and a more delicate touch, so how your manager handles these tenants will have a lot to do with how long they stick around. In turn, this reduces tenant turnover and maintains a predictable income level from the property.

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