Know Your Landlord

When companies enter into a commercial real estate lease the focus is normally on the property, its appearance, amenities, location, and a host of other factors.  What often gets overlooked is the fact that you’re not entering into a business arrangement with a building or its leasing company or its property management group, you are entering into a relationship with the building owner.  Given the long-term nature of most real estate leases, it’s critical that you understand and evaluate the owner along with its motivations and financial wherewithal. 

OWNER TYPES / STRUCTURE

While most commercial buildings are legally owned by single purpose entities such as limited liability companies (e.g., 420 Main Street, LLC), the real owner behind the entity may be an individual owner, a local ownership group, a pension fund or group of funds, a public or private REIT (Real Estate Investment Trust), an insurance company or other institutional owner or a foreign investor.  Ownership may be further obscured by its management and oversight by a professional real estate group (e.g., ABC Realty Advisors) whose funding comes from a money partner but the relationship is less than transparent.  It’s not always easy to discern where the money comes from in an ownership group, but it’s important to ask the questions and understand before entering into a long-term commitment.

OWNER MOTIVATIONS

Different owners have varying motivations that should be understood.  Institutional owners such as pension funds and insurance companies are often focused on long term investments that will both generate a stable return and appreciate in value over time. Many entrepreneurial investors on the other hand are looking for “value add” opportunities where they can invest capital in property improvement and leasing, create a higher stabilized cash flow and sell for a short-term profit.  In the case of a troubled property that is in foreclosure or may have already been transferred to a lender, the lender is likely looking for the most expeditious way to dispose of the property and minimize its losses.

FINANCIAL WHEREWITHAL

A critical aspect of evaluation of an owner is its ability to fund the capital needed to maintain and improve a property, as well as to fund operating losses if rent collections are insufficient.  This is generally not an issue with larger institutional investors, but beyond the ability to provide the funds one must consider the willingness of ownership to do so as well.  Even larger investors are wary about “throwing good money after bad” if the likelihood of realizing a return is remote.  Some of the largest and most profitable real estate investment groups have made the business decision to surrender a property to a lender via a deed-in-lieu of foreclosure rather than continue to feed what is seen as a losing investment.

PROPERTY DEBT

Unlike the single family home mortgage that most of us place on our homes, most commercial real estate is financed with non-recourse debt.  This means that the lender can look only to the property itself to recover its investment.  There is no liability for the ownership group beyond the single purpose ownership entity described above.  If there is no guaranty by a deep pocketed investor, there is little motivation for an owner to continue to fund losses.  In the event of default, the lender will foreclose or otherwise seize the property and the owner will accept its losses to date and move on to the next investment.

Another distinction from home mortgage debt is the shorter duration of commercial mortgage debt.  Commercial mortgages, while structured to amortize over a 20 to 30 year term, will frequently mature (i.e., balloon) after five to ten years.  This forces a borrower to sell or refinance the property at a point in time where conditions may not be favorable.  Interest rates may have risen from the date the property was originally financed or lender underwriting standards may have tightened.  If the leasing market has deteriorated or the property itself has experienced a decline in cash flow due to a loss of tenants, refinancing will be much more difficult.

A good understanding of the debt structure and maturity of the debt is meaningful both to evaluate risk and to identify possible opportunity.  If debt is maturing soon, an owner’s motivation to stabilize the cash flow being generated can enhance the negotiating leverage for an existing or potential new tenant.

SO WHAT DOES A TENANT DO?

The key is understanding the underlying ownership and financing to evaluate whether there are any meaningful risks or, as noted above, opportunities.  A qualified tenant representation broker should be able to obtain this information through various sources and offer insights on the potential risks involved.  Beyond that, a well written and negotiated lease document can afford some protections in the event of a transfer of ownership to a new buyer or lender. Areas of focus would include procedures for tenant recourse in the event of landlord default and a non-disturbance agreement with the lender.