Finding the right tenant pivotal in commercial success
Buyers agent Scott O'Neill takes a look at why having the right tenant mitigates risks and improves the prospects of a good return as a commercial investor.
Finding the right tenant is an important part of a commercial property deal.
Let’s take a look at why having the right tenant mitigates your risks and improves your chance of a good return as a commercial investor.
You can complete your due diligence on the tenant
With leased investments, the property is sold with the tenant already in place.
Having a solid tenant in place from the get-go enables you to know exactly who you are dealing with. You will be able to review the current tenant’s business model, payment history, annual statements, lease details and fit-out contributions, to better assess their viability as a long-term tenant. This in turn can help determine if the property is an investment-grade asset.
Questions to ask: How long have they occupied the premises? Is their rent up to date? Do they have the financial resources to meet the rental payments? Even ask them how long they want to stay at the property. It can pay to ask for bank statements from the landlord that show the tenant’s payment history clearly displayed, to check whether they have paid their rent on time each month. This creates a lot more certainty when buying.
You can establish your cash flow
The aim of a commercial property is to have a secure and uninterrupted cash flow to give you a reliable passive income. The aim is to have a consistent and increasing rental income that also creates equity in a property.
Because the value of an investment property is often closely tied to the strength of its lease, it’s very important to have a strong tenant that can be relied on year after year. However, even more important than this is buying in an area where you can easily re-let the property should that tenant ever leave.
Certain properties will attract longer-term tenants than others, for example dental surgeries, veterinarians or childcare centres. This is due to their specialist zoning, recession-proof style business model and expensive fit-outs.
Property fit-outs can run into the hundreds of thousands or even millions of dollars. Such investments mean tenants will be reluctant to leave, even if they find cheaper rent down the road. We advise you to look for strong secure corporate or blue-chip tenants, or any tenant with a long successful trading history.
Questions to ask: If you’ve found a commercial asset with an A-class tenant, you’re already halfway there. The importance now lies with their lease expiry. Are they willing to renew or extend their lease? How long have they been on the premises already? For example, some tenants have been at the same premises for years, and due to this investment, it’s in their best interests to stay long-term.
However, multiple-tenant assets may have all their leases expire in the same year. Although not a deal-breaker, it certainly adds to the risk, so be sure to find out.
You can understand if they are ‘valuable’ or ‘invaluable’
One thing to note when it comes to commercial property is not all asset classes are equal and that means not all tenants are as valuable as others.
For example, one of the most highly sensitive types of properties to the tenant's quality is a service station asset. Your initial investment may be based on a successful service station business, however, what if that tenant leaves? You are banking on an equally successful service station tenant taking over the lease, as you don’t have the luxury of finding another type of tenant. This is because a service station only has one use unless you totally redevelop it, which would cost millions. As a result of this extra risk, banks will often lend you no more than 55 per cent on this type of asset compared to up to 80 per cent on other types of commercial property.
On the other end of the spectrum (the lower risk side) we look at industrial assets, where relatability is very strong because there are many different types of tenants that would want to lease a warehouse (e.g. storage, manufacturing, online sales, cold storage, etc).
Because of this easy relatability, strong leases may not attract as high a premium in price because the implied risk of not having a tenant is less for industrial assets. Industrial properties also have a very strong owner-occupier market.
Questions to ask: What are the incentives needed to attract or keep a good quality tenant?
Often when you find a new tenant, there is the offer of one month’s free rent for every 12 months they sign on.
For example, a three-year lease might have a three-month rent-free period. This is not all bad as you will frequently collect a three-month cash bond up front from the tenant that can be held in your personal bank account.
The point here is understanding the variation of incentives within different markets. For example, some CBD office markets need to offer 30-40 per cent of the lease value as an incentive.
Sounds high, right?
That's because there is currently so much office space to choose from, you need to be extra generous with new tenants to get them into your property. Other types of assets on the other hand may have zero incentives due to the power being in the landlord's hands.
Understanding your tenant, the incentives in the market, the relatability of a property and the value of your current tenant/lease is all part of being a good commercial investor. Of course, the physical property you purchase is an enormous part of the equation for success but commercial investors also have to be experts in all aspects of the leasing market.
Besides the yields, this is one of the biggest differences between residential properties versus commercial properties.