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Commercial Real Estate Finance Report (Assessment)

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Updated: Mar 11th, 2022

Importance of tenant credit in real estate

In the real estate industry, knowing if your tenant will be compelled to default on its lease obligation or continue to pay the rent for the entire lease period, is equal to knowing the difference between success and failure. In these financial turmoil times, it has become difficult to know whether a tenant will continue to pay rent for its entire lease term or whether the tenant will be compelled to default on its lease obligation. As a property owner, you should be concerned about the possibility of tenant default, because the costs of losing a tenant can be considerable. Certainly, the cash flow will be disrupted, mortgage covenants may be jeopardized, and the costs associated with refitting the space or finding a new tenant are not inconsiderable.

Unfortunately, the real estate industry has not been very concerned with tenant credit scores, or history. In other financial sectors of the market, this method is widely known and practiced. It is time for the real estate industry to learn from fellow industries and ‘borrow’ their techniques and method for the sake of its own future.

The financial crisis made it very clear that if you do not have a clue of the financial potential of your tenants, then you are playing a dangerous gamble. That is why companies, and our, in particular, should begin to design and implement methods of tenant credit screening to safeguard the financial health of the company. And since there is a gap in the industry, if we began our efforts to design and implement such a system now, we can have a very powerful tool of competitive advantage in the market for the future.

Modes of screening tenant credit

“Financial considerations are one of the few reasons you can deny tenants housing under the Fair Housing Laws, so running a tenant credit check gives you grounds to make a decision on whether to rent to a tenant. If a tenant has a pattern of missed payments and a poor credit score, you may want to consider charging a higher deposit, requiring a co-signer, or finding another tenant.” (Carey, 1)

As harsh as they might seem, it is still the only way you can safeguard the future of your company. Using the Altman Z-score methodology of using financial ratios can seem a good start but in this industry, we still do not have the same level of data collection as in other related industries.

First, in order to begin this sort of data the company has to acquire the potential tenant’s permission for accession to his credit history. This can be included in the rental application form in a part where the applicant sings to give you permission on running a credit history. What every rental application should involve is “complete personal information on the tenant, including current address, date of birth, and social security number, to ensure you have the information you need. Of course, you have to make sure you keep all sensitive personal information locked up, either in a locking file cabinet or in a locked room, to protect it” (Carey, 1).

Something else our company should consider is the current employment status of the potential tenant. This should be done along with the employment history of the potential tenant. The current employment status and prospectus will provide our company with an idea of the potential income, or incomes, of the person requiring rent.

Its employment history will help to have a clearer picture of his professionalism and the abilities he, or she has. For example, if a person has changed several employments during the last years with considerable unemployment gaps in between it can be deduced that his financial situation can fluctuate a lot. The main problem is that these fluctuations can be dramatic in the way that he could default on his rental contract as he will not be able to pay it anymore. The current employment, profession, the potential tenant has served the same purpose. We can make some research on that company, or even industry, he is employed and see the prospect for the future. For example, we find out that the potential tenant is employed in a certain sector of a manufacturing company. Market research shows that that company has not done well and that has plans to cut down its workforce in certain sectors, one of which is the one our potential tenant works in.

This means that this person has a high probability of being laid off from employment and thus, cut down of his main form of income. Of course, this person has higher probability of rental default than another who works in a company that is thriving. Thus, by inserting the employment history for the last couple of years we can have a clearer picture of this situation. We need to know the income potential of these applicants and their future possibilities. Of course that this method is not perfect, but it can certainly narrow the prospects of having many default tenants.

References

Carey, Daniel. “How to run a tenant credit”, Life 123 Online Magazine. 2010. Web.

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IvyPanda. 2022. "Commercial Real Estate Finance." March 11, 2022. https://ivypanda.com/essays/commercial-real-estate-finance/.

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