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The importance of prequalifying office prospects.

Prequalifying prospects has always been an important part of the leasing program for any building. However, today's economic conditions make it more important than ever to establish a tenant's financial stability before signing the lease.

Due to the abundance of office space available in many areas of the country, there are very lucrative deals being offered to fill vacant space. Tenants are being lured with major free rent concessions and build-out inducements, and many times are overextending themselves by leasing more space than they can ultimately afford.

There is also a rising incidence of tenant defaults plaguing owners today, which is caused not only by tenants overestimating their space requirements, but also by the recession. Many major corporations have downsized their staffs to prepare for leaner times. In the past two years, defaults have risen from less than 1 percent of a building's rentable area to in excess of 5 percent in many buildings.

It is not uncommon to hear of tenants defaulting on leases right after coming off a free-rent period. These tenants were probably not good risks from the beginning. Had emphasis been placed on thoroughly reviewing their financial condition before leasing, the result might have been evident from the start.

Your building's image is based on the quality of its tenants. This does not mean that they all have to be Fortune 500 tenants. Small tenants can also be quality tenants, but they must be financially sound.

Financial prequalification

Owners and managers need to establish guidelines for judging a prospective tenant's credit before entering into a lease agreement. Unfortunately, if you ask many managers today how they decide whether or not to lease to a prospect, they will say, "It is a gut feeling." While that might work sometimes, it is difficult to explain to owners when defaults reach all-time highs as they have today.

Checking a prospect's financials should be a routine part of a leasing manager's procedure when leasing a property. A credit report can be obtained from Dun & Bradstreet or your local credit bureau. In addition, the leasing manager may also request a copy of the company's financial statements - preferably audited - for the last several years to be used in evaluating not only the current financial status, but also future trends. A balance sheet and a profit-and-loss statement may be an acceptable substitute.

If the company is a subsidiary, request the parent company's financials in addition to the subsidiary's. The parent company should sign or guarantee the lease. In some cases you may want to request a corporate tax return.

There are four important items to check on a financial statement. While some financials require more in-depth study, if you perform these four tests, you will be in a better position to evaluate a prospect's financial condition and thus to determine whether or not to proceed with lease negotiations. Please note, a prospect's credit should be reviewed at the point a prospect has expressed interest in your property, not after four weeks of lease negotiations with attorneys.

Analyzing a financial statement

Financial statements consist of two parts: a balance sheet and an operating statement. Each are analyzed separately A typical Balance Sheet consists of assets and liabilities (Figure 1).


Ratios are used as indicators in evaluating the financial condition, efficiency, and profitability of businesses. One concern in analyzing financials is whether or not a company can meet its maturing obligations. Liquidity ratios are used to determine the viability.

Current ratio, sometimes referred to as working capital ratio, compares current assets to current liabilities. Current assets divided by current liabilities equals current ratio. ($70,000/$30,000 = 2.23 to 1.) Working capital is an indication of the ability of a business to pay its current liabilities as they mature.

A good rule of thumb for evaluating financial health is a current ratio of at least 2 to 1. If the ratio falls below 1.5, caution should be exercised.

It is important to analyze why the current ratio has changed. If a bank loan was reduced, for example, the question is "Was the payment voluntary or required by the bank because of a lack of confidence?"

Industry averages are used to compare the current ratio. While these averages can be used as a guideline, a decision should not be made solely on the current ratio. Some well-managed firms might be above or below the average. A ratio that is extremely out of line should cause the manager to look further into the prospect's financial condition, however.

Inventories are the least liquid of a firm's current assets, because they cannot easily be turned into cash to pay current liabilities. A quick" ratio subtracts inventory from current assets ($140,000 - 100,000), and divides by current liabilities ($30,000 = 1.3%). In this computation, only the assets that are liquid are considered.

As the industry average is 1 percent, the ratio appears to be favorable. However, a comparison should be made of the previous years to see if there is an upward or downward trend.

Trends in net income to net earnings ratios should also be reviewed. Again, compare them to industry standards and review for previous years.

A primary reason for the operation of a corporation is to earn a profit for its shareholders. In many small companies, the shareholders work for the corporation. Therefore, it is important to look at their compensation and analyze the effect on profits.

Net worth is the amount by which the total assets exceed the total liabilities. A prospect's ability to borrow is also important to review. (Net worth divided by total liabilities yields a debt-to-equity ratio: $95,927/$206a,018 = 46%. This should not exceed 50 percent.)

If financial statements are not available, secure the prospect's home telephone number and address, major suppliers (at least two or three), banking references, the previous or current landlord, and a personal tax return.

Even if a prospect's financials might not be what you would like to see, you still may wish to work with them to structure a deal to meet their needs and still give you the comfort of knowing the risk. For instance, you may want to offer less free rent or less build-out. A higher rental rate or an increased security deposit could be negotiated.

Reviewing renewals

Not only is it important to review the financial condition of new tenants, but also that of renewal tenants. First and most importantly, there are definitely warning signs of tenants who are having cash-flow problems. These range from late rent payments each month, through NSF checks, to missed rent payments entirely. If no remedy is foreseen, a timely recapture of the space might be warranted.

Every owner, at some time or another, has been approached by a tenant requesting a payment plan to repay delinquent rent. Please make a mental and written note right now-payment plans for delinquent rent seldom work. If a tenant cannot pay its regularly scheduled monthly rent, how can it pay one and a half or two times the rent each month? The answer is, it cannot.

It is better to cut your losses if it is evident the problem cannot be remedied. Something is not better than nothing because a tenant who does not pay rent is tying up valuable space.

If a remedy is not foreseen, the manager should begin eviction, recapture the space, institute proceedings against the tenant for delinquent rent, and immediately begin marketing the space.

Case study

Two true cases illustrate the importance of prequalifying prospects.

A shared office facility in existence less than two years approached a manager about opening an office in the Chicago area. At the time, the market was not much better than it is now. Owners were very eager to show leasing activity, and all deals were being reviewed.

The firm wanted to lease approximately 20,000 square feet, which accounted for about one and a half floors of the building being considered. The company did not have a financial statement showing previous operating history, as they were just opening up offices throughout the United States.

However, the company's owners all had previous experience operating such facilities. Of course, these owners were not agreeable to guaranteeing the lease personally.

Not only did the prospect expect major rent concessions, moving allowances, and above-standard build-out, but it also required a cash allowance as an inducement. Further discussions revealed the cash was needed to buy furniture for the new facility.

If that was not enough to kill the deal, a further check on the company's other newly opened locations across the country revealed they had never paid any cash to any owner. They were on free rent in all their locations. This was not a good risk regardless of the market, and the deal was not done.

The second example involved an HMO facility interested in leasing a full floor of space, approximately 22,000 square feet. Again, the economics were very aggressive. The HMO was affiliated with a major hospital, but no one was willing to guarantee the lease. The deal was declined by the owner and ended up in a building down the block.

Every time an owner passes on a deal, he or she still worries, "What if the market gets worse?" and "Maybe it wasn't such a bad deal after all.' But, analyses should be trusted. One year later, the HMO closed its doors, leaving the building down the street with the recapture of 22,000 square feet, not to mention the hundreds of thousands of dollars expended toward the special build-out.

The moral of these two true-life cases is that an owner needs upfront guarantees from tenants that rent will be available for the life of the lease. If the tenant has not expended any money for either improvements, security deposit, or rent, it is easy to walk away from the space.

Making a lease viable

There are ways, however, to help an owner overcome or lessen his or her resistance to a prospect's financial limitations. This can be done by turning limitations into advantages.

Deals should be tailor-made to meet a prospect's particular needs. It is very possible that a prospect might not be able to pay the owner's stated rental rate. But he or she might also not need a large rent concession. A lower rate per square foot could be negotiated in lieu of a rent concession. In this way, the owner receives rent from day one.

Graduated rent could be negotiated to assist the tenant in the early years of the lease. A lower rate per square foot combined with a gradual increase two or three times during the lease term may be warranted for a company facing short-term problems.

Increasing the amount of security deposit if anything about the deal is questionable is another way to protect the owner from default. Instead of the typical one month's security deposit, the manager could negotiate a two-or-more-month security deposit (even six, if necessary) to give reassurance of the tenant's ability to pay rent. This is particularly advantageous when an owner does not have to expend a large amount of money to get the tenant in the space.

Personal guarantees are being required more often than ever before, particularly for small and start-up businesses. Be sure to check the personal finances of those making the guarantee.

In summary, the prequalifying of prospects and the requalifying of renewal tenants is essential to the successful leasing of any property.

Patricia L. Trombello, CPM [R], is president of Technical Training Consultants, Inc. and its subsidiary, TTC Realty Group of Oak Brook, Illinois. She serves as a trainer and consultant for commercial real estate, specializing in programs on lease negotiation and marketing commercial property.

Ms. Trombello has developed a leasing software program, "NPV," for analyzing commercial leases. Her firm also provides fee management and brokerage services. Prior to forming her own company, Ms. Trombello was a regional branch manager for Manulife Real Estate and a vice president of E. N. Kelley & Associates, Inc.

Technical Training Consultants conducts a one-half-day training program entitled "Understanding Financial Statements." The course, taught in conjunction with Ronald Kot, CPA, combines accounting with practical real estate experience in analyzing financial statements.
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Title Annotation:screening of office tenants
Author:Trombello, Patricia L.
Publication:Journal of Property Management
Date:Sep 1, 1991
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