Why net lease tenant health checks matter

Assessing tenant creditworthiness is just as important as the physical asset in a net lease deal, but demands a very different set of skills from property investors.

Net lease strategies have grown in popularity in recent times as private investors are attracted by the combination of real estate’s inflation-proofing characteristics and stable, high-quality, bond-like returns. While such deals were popular in the low-rate environment, when borrowing was cheap and rates were low, activity in the market has experienced a drop off as central banks raised interest rates to combat higher inflation.

But the higher-rate, higher-inflation environment is having a notable impact on tenants, too.

Inflation has increased costs for many companies, which are being forced to pass these on to their customers, plenty of whom are already struggling in a lower-growth environment. With less pricing power, some companies are facing narrower margins and higher operational costs – including rent.

“The appeal of net lease investments lies in their defensive, income-focused nature, with the aim of delivering stable, more secure and inflation-linked cashflows,” says Nicole Mitchell, head of real estate strategy and policy at London-based law firm Macfarlanes.

“As such, the ability of the tenant to meet its contractual obligations becomes a primary investment risk.” This is a particularly critical issue in ‘triple-net lease’ agreements, which will include property taxes, insurance and maintenance, in addition to rent, says Mitchell.

As such, private real estate investors need to make sure that the income on their net lease investments is protected. One of the best ways they can do this is by ensuring the creditworthiness of their tenants.

But assessing the credit health of tenants demands an entirely different set of skills to assessing the value of a physical property asset and undertaking rental yield forecasts. So, how can investors proceed?

Identifying the risks

Many factors can directly or indirectly impact a tenant’s ability to pay their rent, notes Alistair Calvert, chief executive of pan-European manager Clarion Partners, including an economic downturn and increased competition in the industry the tenant operates in, as well as high financing costs.

Often, however, it is also one-off events or trends that result in a substantial loss of revenue or higher costs that can prevent a tenant from keeping up with its rent payments, he adds, and this is something that Clarion monitors regularly.

“Tenant creditworthiness is a key risk for investors because most of the projected return in net lease investments comes from income rather than realized value on exit,” says Calvert. “To mitigate against credit risk, we conduct thorough due diligence on prospective tenants and implement the necessary credit security measures depending on the outcome of the credit underwriting process.”

Equally important, Calvert says, is to monitor the tenant’s financial performance on a regular basis. And then, while credit risk is key, it is only one part of the overall investment risk, with real estate being the other major component.

“In this regard, we seek protection by ensuring any assets we are involved in are ‘mission critical.’ It is also important to ensure that they are generic assets, adaptable to change of use in case the tenant needs to vacate the property,” says Calvert.

Zac Goodman, chief executive of TSP, a real estate investment and asset management business, says the weight his firm gives to the creditworthiness of its tenant will depend on what percentage of the investment the tenant’s lease commitment represents. Meanwhile, understanding a tenant’s funding can be a good indicator of its ability to meet its lease commitments.

“Extra care and attention should be taken with start-up or VC-funded business,” says Goodman. “Looks can be deceiving when a business has just raised $50 million but has negative cashflow. How long will these funds last at the current run rate, and what is the expansion plan? How does this compare with the size and length of the commitment?”

What a tenant does – in other words, the type of industry it operates in – can also give investors better insight into the short-term challenges it may face and what impact those challenges could have on its business.

For example, there are certain types of tenants, particularly in the office and retail sectors, which have found themselves overexposed to physical space in the wake of fundamental changes to how we live and work, particularly changing working patterns and reduced footfall in CBDs due to the impacts of covid and online retail. And other tenants have had to reappraise short-term business plans in the face of higher inflation, rising interest rates and poor prospects for economic growth.

Third parties or in-house?

The long-term nature of some leases, which can typically last longer than 10 years, means that a tenant appraisal is more like a credit strategy underwriting exercise, says Macfarlanes’ Mitchell. Such a process can involve analyzing the tenant’s financial strength, ability to meet lease obligations and its long-term business plan. 

“Those managing credit strategies alongside real estate strategies are particularly well suited to net lease investing, as they can draw upon the ‘dual skillset’ required to underwrite both the credit risk of the tenant and the fundamentals of the real estate at the same time,” she says.

“We have observed a broad spectrum of investors and investment managers looking to access net lease investing in its various forms, from UK pension funds to private equity houses – there really is no ‘one-size-fits-all’ approach.”

While there are many third parties that can offer such services, they are often best kept in-house, says Calvert, as that grants greater control over the underwriting process and can lead to quicker decision-making, greater confidentiality and more alignment with a firm’s investment strategy. It can also give a manager a better insight into their client’s business and facilitate relationship management.

“We do a full a credit underwriting in the same manner corporate lenders would their full underwriting,” he says. “We don’t focus just on day-one balance sheets but also on other factors that may impact the tenant’s creditworthiness over the mid to long term, such as the competitive landscape and industry dynamics.

“By conducting all these checks, we can thoroughly assess a tenant’s financial standing, operational capabilities, and overall suitability for the sale and leaseback transaction. We also require tenants to provide us [with] ongoing financial statements on a quarterly or annual basis to monitor their financial situation.”

While rating agencies might be able to provide an insight into the creditworthiness of some tenants, often only those with publicly-issued debt will be rated. Additionally, in some cases, third-party services may not be completely reliable, says TPS’s Goodman.

“In terms of understanding the creditworthiness, we have found that third-party ratings and reports have little use and are often out of date,” he says. “Ultimately, in our view, the same care and attention and due diligence should be taken as if you were investing in the business or looking to buy its stock.” A good accountant is often a great adviser in these scenarios, adds Goodman. 

Being prepared

Net lease investing can offer investors a range of attractive investment opportunities, particularly as more companies look to free up working capital through the disposal of their real estate holdings, which has resulted in several high-profile deals in recent years. And established investment managers are often able to source a pipeline of new deals, says Clarion’s Calvert, which can mitigate tenant risk from the outset.

“The ability to originate sale-leasebacks rather than purchasing existing leased assets is often underrated and can lead to strong value creation at lease commencement,” he says. “Often, these transactions are found off-market and require access to an established network.”

Another way that investors can mitigate tenant risk is by ensuring they are invested only in properties that meet their own investment requirements and can be adapted for new tenants, says Calvert. 

Nevertheless, tenant creditworthiness remains a key issue for investors and is something that must be addressed properly. And in some circumstances, the tenants’ creditworthiness could be a key factor in the value of any potential deal, says Macfarlane’s Mitchell.

“In many examples of net lease investments, the impressive deals stand out as a result of the stellar credit position of the tenant rather than the characteristics of the real estate asset itself,” she explains. “A low-risk, strong, long-term covenant, such as a public or quasi-public body, could be the goose that lays the golden eggs.”