Often a prospective tenant’s ability to pay rent is unknown to the landlord. Therefore, its imperative that the landlord is particularly vigilant in understanding how their tenants make money, as well as the financial identities of the parties backstopping the obligations of those tenants in new-venture or start-up businesses.
As the success of leased real estate is highly dependent upon the stability of its tenant, landlords should always analyze tenant credit in the context of the lease. While rent is the primary economic factor in a lease transaction, other factors such as term, area of the premises, and the scope of tenant improvements create the platform for which a tenant’s credit should be evaluated. There are multiple ways in which a landlord should ensure their prospective tenant’s credit to guarantee that the tenant is able to fulfill their rent and financial obligations to the landlord. In this article, we will look at three ways in which to ensure tenant credit.
A proper underwriting of a tenant’s credit requires a thorough understanding of that tenant’s business. A diligent landlord will pay attention not only to the tenant’s sources of revenue, but also to the market upon which the tenant relies and the business plans upon which the tenant maps its future success. Furthermore, landlords can avoid doing business with troubled or unstable tenants by performing background, lien and litigation searches on the tenant as part of the underwriting process.
While cash security deposits have historically been the industry standard in commercial leasing, landlords are increasingly favoring letters of credit security deposits, sometimes instead of the cash deposits. For many landlords, the benefits of cash on hand are overshadowed by the security of an obligation issued by a third-party bank, primarily when the landlord is able to draw on the letter of credit following a default without notice to or consent by the tenant. Letters of credit are more secure because, unlike a cash security deposit, it isn’t an obligation of the tenant, and instead the obligation falls upon a third-party.
Guaranties are a common alternative for securing the credit of a commercial tenant. A guaranty is a legally enforceable undertaking by a third-party to fulfill the payment of performance obligations of the tenant under a lease. A guaranty may be given by an entity, such as a corporate parent or affiliate, or an individual, such as the majority owner of other key principal of the tenant. A typical landlord form guaranty will obligate the guarantor to reimburse the landlord for any and all damages suffered by the landlord due to the default of the tenant including attorneys’ fees for the entire term of the lease.