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Owners should loosen tenant credit policies.

We all know that owners' costs of tenant finish, lease assumptions, free rent, and other concessions have increased dramatically in the current competitive market. In addition, the general sluggishness in business conditions is reducing tenant viability, thereby adding to the risk of tenant default or outright bankruptcy.

For protection against these dual challenges, landlords have been turning to stricter tenant credit standards or to some form of credit enhancement, such as letters of credit. However, stricter credit may actually be counterproductive and result in reduced cash flows and lower asset values by unnecessarily prolonging vacancy.

Is there anything wrong with tighter credit? After all, there are important benefits.

For example, consider letters of credit. Letters of credit transfer the credit analysis function (not a simple task) to experts: the banks. The presumably better credit of a bank replaces the uncertain credit of the tenant. The tenant carries the direct cost of the credit enhancement. Most importantly, unexpected landlord losses should decline.

The cost of lost opportunities

Tight credit, however, can in fact be less profitable for the owner than looser standards. For example, many other businesses (that sell goods and services) have long accepted bad debt as a cost of business. Indeed, reductions in receivables or bad-debt expenses sometimes indicate that credit standards are too tight and, as a result, sales are being lost.

Applying this concept to real estate operations suggests that overly strict credit requirements also lead to lost sales. Otherwise desirable tenants are denied leases.

As an example, consider the down side of letters of credit. Tenants resist this requirement because of high costs in addition to the annual fee. Letters of credit are contingent liabilities with negative balance sheet effects than hinder other financing. Banks usually require pledged collateral such as non-interest-bearing compensating balances. The tenant suffers annual risk of lease default if the bank fails to renew the letter of credit.

Tighter bank credit standards reduce the number of firms that qualify for letters of credit. This creates a paradox wherein the tenant who needs a letter of credit most cannot get it. A possible outcome for the landlord is a lost lease opportunity and, as a result, continuing vacancy.

In view of high startup costs (e.g., tenant finish, commissions, legal fees), a lost lease might not be a problem, especially if failure to qualify for a letter of credit indicates high risk. Indeed, avoiding tenant default is a desirable objective. By eliminating all potential tenants who do not meet the tight credit standards, the landlord certainly achieves this goal.

But the landlord also will lose opportunities. An implicit presumption behind this policy is that tenants that do not meet landlord or bank credit standards will fail. Fortunately, this is not true; not all risky tenants default. However, the owner may forgo profits from leases to tenants who would have consistently paid rent if given leases in the first place--a high long-term cost for short-term savings in leasing costs.

Managing tenant credit on a lease-by-lease basis unavoidably leads to missed opportunities. A better approach may be to borrow some concepts from business credit practices.

* Accept tenant default as a cost of business. This recognizes that some tenants will not pay rent, but most will. Then, ownership can assess its tolerance for bad-debt costs and establish credit policy and allowances accordingly. This does not necessarily mean zero loss.

* Manager tenant credit across buildings or, better, across entire portfolios. Spreading the bad-debt costs across the portfolio moderates the financial effect upon total value. Further, by using a portfolio concept, the owner can reduce risk through diversification. A planned mix of tenant businesses, building types, and geography offers some degree of protection against localized business downturns in regions or industries.

* A final important concept to borrow from general business is contribution margin. Here, the landlord should analyze increases in a building's or portfolio's cash flow due to new lease revenue. Essentially, ownership should look past the traditional measure of lease profitability--net effective rent--and consider instead a lease's contribution to profits.

A small incremental cost

Real estate enjoys relatively low variable costs (for any single tenant, truly variable costs are small--primarily cleaning and management fee) and thus, a high contribution margin. As a result, almost all revenue from the incremental tenant goes straight to the bottom line.

The consequences of real estate's high contribution margin are significant. Property and portfolio values improve dramatically. Added revenue brings more than proportionate profit increases that, in turn, cause more than proportionate value increases. Potential losses due to tenant default on an individual lease shrink because the high contribution margin accelerates the payback of upfront leasing costs.

Real estate is a unique investment, but aspects of its operations are like other businesses. Therefore, our industry can learn from long-time practices of general business. A key example is credit management, especially the concept that bad-debt expenses are a cost of doing business.

Accepting this idea opens a wider pool of prospective tenants and more leasing opportunities. Given real estate's high contribution margin, the cost of not doing a lease is considerable; the gains to be realized from an increase in revenue are great. Consequently, relaxing credit standards will enhance property and portfolio performance and value.

[Andrew J. Weddig manages real estate planning for Rubloff Asset Management. In this role, he oversees the strategic investment planning for properties in the Rubloff management portfolio. He has also been involved in valuation and appraisal for institutional clients.]
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Title Annotation:Viewpoint
Author:Weddig, Andrew J.
Publication:Journal of Property Management
Date:Sep 1, 1992
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