What are the best practices for evaluating commercial tenant default risk?

1 Check credit and financials

One of the most common ways to evaluate tenant default risk is to check their credit and financial history. You can use credit reports, bank statements, income statements, balance sheets, and tax returns to verify their ability and willingness to pay rent on time and in full. You can also look for indicators of financial distress, such as late payments, defaults, bankruptcies, lawsuits, or liens. A higher credit score and a stronger financial position generally indicate a lower tenant default risk.

2 Review lease terms and clauses

Another way to evaluate tenant default risk is to review the lease terms and clauses that govern the relationship between you and the tenant. You want to make sure that the lease terms are clear, fair, and enforceable, and that they protect your interests in case of default. For example, you can include clauses that require security deposits, personal guarantees, rent escalation, late fees, or termination rights. You can also negotiate clauses that allow you to adjust the rent, modify the space, or sublease the property in response to market conditions or tenant needs.

3 Analyze market and industry trends

A third way to evaluate tenant default risk is to analyze the market and industry trends that affect the demand and supply of commercial space. You want to understand how the macroeconomic and microeconomic factors influence the performance and profitability of your tenant's business. For example, you can consider the impact of interest rates, inflation, consumer spending, competition, regulation, technology, or innovation on your tenant's industry and sector. A more stable and growing market and industry generally indicate a lower tenant default risk.

4 Conduct site visits and interviews

A fourth way to evaluate tenant default risk is to conduct site visits and interviews with the tenant and their employees, customers, suppliers, or partners. You want to observe how the tenant uses and maintains the space, how they interact with their stakeholders, and how they cope with challenges or opportunities. You can also ask questions about their business plans, goals, strategies, challenges, or opportunities. A more satisfied and loyal tenant, with a positive and professional attitude, generally indicates a lower tenant default risk.

5 Monitor performance and communication

A fifth way to evaluate tenant default risk is to monitor their performance and communication throughout the lease term. You want to track their rent payments, lease compliance, occupancy rate, sales volume, customer feedback, or financial statements. You also want to maintain regular and open communication with them, to address any issues or concerns, to provide support or assistance, or to negotiate changes or renewals. A more consistent and transparent tenant, with a good track record and relationship, generally indicates a lower tenant default risk.

6 Implement risk mitigation strategies

Evaluating tenant default risk is a vital skill for commercial real estate investors and landlords. A sixth way to do this is to implement risk mitigation strategies that can reduce the likelihood or impact of default. For instance, portfolio diversification, tenant mix optimization, insurance coverage, and hedging instruments can all be used to spread risk and increase income sources. Portfolio diversification involves investing in different types of properties, locations, tenants, or industries. Tenant mix optimization involves selecting tenants that complement each other and create synergies. Insurance coverage includes rent loss insurance, business interruption insurance, or property damage insurance. Hedging instruments include interest rate swaps, currency swaps, or futures contracts. By taking these steps, you can make more informed and confident decisions about your commercial properties and tenants.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?