When evaluating and selecting tenants for your commercial real estate property, it is natural to seek the tenants who will pay the maximum amount of rent. While that is undoubtedly an important consideration, it should not be the only factor when vetting prospective tenants. It is of equal importance to identify and select reliable and stable tenants who are compatible with your property’s overall tenancy. To follow are three crucial evaluation areas and strategies to consider when evaluating and choosing prospective tenants:
1. Tenant Use: It is essential to clearly understand how a prospective tenant plans to use the space and whether their use complements the property and existing tenancy. For example, if you own a mixed-use property with retail space on the ground floor and offices above, leasing the bottom floor to a fitness center that offers daily exercise classes with loud music may be disruptive to the office tenants above. As another example, if you own an office building with limited parking, a prospective tenant with employees who commute may not be the best fit. If parking issues are exacerbated, selecting this type of tenant may hinder your ability to lease future space or retain existing tenants.
- Selecting the wrong tenant can cause significant disruptions to your business. Therefore, it’s critical to understand a prospective tenant’s intended use for the property and obtain as much information as possible about their operation. Ask a prospective tenant about their parking needs, hours of operation, number of on-site employees, and related criteria. The more you learn upfront, the more likely your new tenant will be a positive addition to your property.
2. Tenant Experience: Identifying tenants who are willing to pay your desired rental rates is obviously very desirable. However, that only matters if they stay in business and remain profitable. If you are leasing space to an established or well-known company, you are likely to have little cause for concern. For lesser-known companies, you should inquire about their history and operating experience. Many landlords who have leased restaurant space have likely experienced prospective tenants who are enthusiastic about operating a restaurant but did not have experience owning or running a restaurant. Leasing space to a ‘brand new’ entrepreneur is a very risky endeavor. Property owners may be better off leasing space to an experienced operator for less rent vs. a start-up or novice operator. Replacing tenants can often be more costly than receiving extra rental income.
- For prospective tenants whose business is not established or not well-known, a best practice is to inquire about their experience and operating history. For any new prospective tenants, request a business plan and other operating documents to learn about the company’s leadership, their experience, and the owner’s strategic plans.
3. Tenant Financial Strength: If your property attracts Fortune 500 companies, most likely, you can rest assured that your rent checks will arrive on time every month. Unfortunately, those are not your average tenants. Commercial real estate property owners should perform due diligence on all prospective tenants. It is essential to understand tenants’ financial strength to ensure they are sufficiently capitalized and capable of fulfilling their lease obligations. Frequently, a prospective tenant may appear to be a solid business; however, after taking a closer look, the company may not be quite as strong as it appeared. In many cases, property owners will need to carefully review the operations and examine the financial strength of the person(s) who will personally guaranty the lease.
It is vital for landlords to understand their tenant’s financial conditions. This is especially important when work or improvements need to be performed to prepare a space or when a tenant improvement allowance is provided. If property owners have any concerns, the lease can be structured to mitigate risk, i.e., request a larger security deposit, or offer the space “as-is” with no landlord work, etc.
- Property owners should request a current financial statement and recent tax returns from the prospective tenant as part of the tenant screening process. This pertains to the business or entity that will sign the lease and any person(s) guaranteeing the lease. Obtaining a credit report for any guarantors may also provide greater insight and assist in validating other information.
If you are a commercial real estate property owner and would like more information about selecting the right tenants for your space, please contact us. The Innovative CPA Group provides services, solutions, and guidance based on our real-world experience in the commercial real estate industry.