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The New Math of Tenant Creditworthiness

Understanding the creditworthiness of your tenant is one of the most important aspects of successful commercial real estate ownership. The riskiness of tenants can be the difference between profit and default for some properties and tenant strength factors into both a building’s valuation and its ability to take out debt. Like all things these days, the calculations of creditworthiness are changing. Year three of a pandemic with no sign of normal in sight has redefined what a reliable tenant looks like. Some industry stalwarts have been hit hard by disruption and a changing work environment. But the big question is how much an office tenants’ new work policies impact its creditworthiness. 

Creditworthiness starts in the books. Balances sheets, income statements, tax returns, and other official financial records help paint a basic picture of health for any tenant. Rental history gives landlords a timeline to see how a potential tenant has honored their leases and relationships with other tenants. A general assessment of the industry the tenant operates in helps colors in the big picture. But the devil is in the details and the ass is in the assumptions.

Is a tenant that has robust hybrid work policies, allowing employees to work from home two or more days a week, a reliable tenant? Landlords across the country are scratching their heads. Taking an optimistic view, it’s reasonable to think that companies with hybrid work policies during a pandemic are taking appropriate precautions to protect their staff and operations. Regardless of how much they use the space during the pandemic, they’re still paying for it. That’s good for the building’s balance sheet, at least. 

Pessimists might say that using the office less could very likely lead to a significant reduction in space. Worse yet, if a company decides to go entirely remote, they might drop out of the office market altogether. The credit agency Fitch Ratings looked at two different stress level scenarios for 144 single-asset/single-borrower bonds. The first scenario assumes employees work remotely 1.5 days per week, the second assumes 3 days per week. The result of such stress would see “average market-value declines from at-origination appraised values of approximately 44 percent and 54 percent, respectively, for moderate and severe stress scenarios. Were these declines in value to occur, downgrades are possible, with 25 percent and 55 percent of investment-grade bonds potentially moving to below investment-grade.” 

Offices aren’t going away anytime soon, but some portion of tenants are rethinking their real estate strategy in light of how they’ve operated during a pandemic. For office landlords, in particular, determining which tenants are likely to renew or expand is key to a building’s financial health. Not every tenant uses their offices the same anymore. Predicting office leasing depends on understanding and accounting for a tenant’s new workplace policies. 

It may still be too early to think about these things, at least so far as traditional credit and valuation go. With the pandemic still ongoing, the broader world of commercial office landlords, lenders, and brokers are convinced the disruption of workplace usage is a temporary measure of the pandemic. Office buildings have been largely empty for two years now but that’s hardly impacted valuations. Repeated return-to-office delays have so far not led to lease termination en masse or even a significant shrinkage in space needs. On the contrary, rent collection has been resilient. But, office landlords are offering tens of millions of dollars worth of concessions to prop up rent and demand. On paper you can hardly find any sign there’s a pandemic impacting office usage at all. In the real world, things aren’t so simple. 

The office leasing environment is uncertain. Project all the data onto the situation you want, the truth of the matter is that the office sector is waiting for the other shoe to drop. The pandemic has tenants and landlords in wait-and-see mode. Very few occupiers are rushing to make major real estate decisions, must are struggling just to hang on during such a tumultuous time. When (if?) the pandemic calms down, then the reality of the situation will start to settle in. Leasing decisions are based on long-term planning, not short-term market disruptions. A tenant’s attitude toward the office is an important part of their creditworthiness. Work from home policies define that attitude. 

Office landlords took a bath during the 2008 recession. The property value of offices in the U.S. fell over 40 percent. So far nothing like that has happened because of the pandemic. That doesn’t necessarily mean it won’t. Just because a tenant hasn’t made a major real estate decision yet doesn’t mean their landlord will like the one they make when they finally do. In the storm that is the pandemic, seeing the horizon is nigh impossible, but it’s out there. When the skies clear, landlords will need to properly assess the damage. Understanding a company’s workplace and hybrid policies can help office landlords gauge how likely they are to renew, expand, or terminate their lease. Failing to account for the new creditworthiness of tenants could end up impacting the credit of the building itself. For anyone buying into the sky-high real estate valuations we have seen in the last few years, an unforeseen lease termination could be enough to push a building into default. All because the owner didn’t do the creditworthiness math right.

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