When your real estate company seeks financing to acquire or renovate a piece of commercial real estate, lenders don’t just evaluate the building itself. They evaluate the leases that generate the building’s income. For income-producing real properties the leases are often more important than the physical structure. A beautiful, well-maintained office building with weak tenants and short leases is far riskier than an older building with strong, creditworthy tenants on long-term leases.
Your company must understand how lenders evaluate commercial leases because the quality of your property’s leases directly affects the financing your company can obtain. Lenders will scrutinize lease structures, rent rolls, co-tenancy clauses, termination rights, and dozens of other lease provisions. They’ll assess tenant creditworthiness, analyze lease expiration schedules, and evaluate the stability of your property’s rental income. If your company’s leases have problems, your company may face higher interest rates, lower loan amounts, or difficulty obtaining financing altogether.
Your company must understand how lenders evaluate commercial leases because lease quality directly influences the financing terms your company can obtain. should your company need to obtain financing. By understanding the factors important to lenders your company can better structure leases, negotiate with tenants, and present your property in the strongest possible light to potential lenders.
Rent Roll are the Foundation of a Lender’s Lease Analysis
When a lender evaluates your company’s real property portfolio, the first document they request is the rent rolls. A rent roll for a building is a detailed schedule of all leases for the tenants who occupy the property. It identifies each tenant’s name, the total square footage they occupy, their lease commencement and expiration dates, their annual rent, any rent escalations, and any special provisions or exceptions. The rent roll is essentially a snapshot of your property’s income-generating potential.
Lenders use the rent roll to calculate a property’s gross potential income and to project future cash flows. They’ll examine the rent roll to identify lease expirations, to assess tenant concentration risk, and to evaluate the stability of the property’s income. A well-organized, accurate rent roll is essential because it forms the foundation for the lender’s underwriting analysis. If your company’s rent roll contains errors or omissions, the lender will lose confidence in your company’s financial information and may require additional verification or impose more stringent underwriting conditions.
Your company should ensure that the rent roll is completely accurate and up-to-date. The rent roll should reflect all current leases, including any amendments or modifications. If your company has recently signed new leases or renewed existing ones, the rent roll should be updated to reflect these changes. Additionally, your company should be prepared to provide copies of all leases to the lender for verification. Lenders will often conduct a lease audit, comparing the rent roll to actual lease documents to ensure accuracy.
Tenant Creditworthiness Impacts Your Company’s Income Stability
Once the lender has reviewed the rent roll, they’ll evaluate the creditworthiness of each of your building’s tenants. Tenant creditworthiness is crucial because it determines the likelihood that tenants will pay rent on time and in full. A property with strong, creditworthy tenants is far less risky than a property with weak tenants, even if the physical property is identical.
Lenders assess tenant creditworthiness by examining each tenant’s financial statements, credit history, and payment record. For large, publicly traded companies, lenders may rely on published financial information and credit ratings. For smaller, private companies, lenders may request financial statements, tax returns, and bank references. Lenders are particularly interested in each tenant’s debt service coverage ratio—whether the tenant’s business generates sufficient income to cover rent payments and other obligations.
Tenant creditworthiness directly affects your company’s ability to secure favorable financing for a property. If your company’s property is anchored by a strong, creditworthy tenant like a major national retailer or a Fortune 500 company, lenders will view the property as lower-risk and may offer better terms. Conversely, if your company’s property is occupied by smaller, less creditworthy tenants, lenders will view the property as higher-risk and may impose stricter underwriting conditions or offer less favorable terms and higher borrowing costs.
You Must Understand and Manage the Risks Posed by Expiring Leases
Lenders pay close attention to lease expiration schedules because they want to understand when your company’s rental income could be reduced and by how much. If all of your company’s major tenants have leases expiring in the same year, the property could face significant risk of non-renewal of some of its leases. If a large tenant doesn’t renew, your company’s rental income could decline dramatically, making it difficult for your company to service debt.
Lenders prefer properties with staggered lease expirations, where different tenants’ leases expire in different years. This approach spreads the risk of expiring leases over time and ensures that your company’s rental income remains relatively stable even if some tenants don’t renew their lease. When evaluating your company’s property, lenders will create a lease expiration schedule showing which leases expire in each year over the next 5 to 10 years. They’ll then stress-test your company’s cash flow by assuming that some number of tenants won’t renew and that market rents for those that do renew may be lower than the current rents on your rolls.
Your company should think strategically about lease expiration schedules. When you’re negotiating new leases or renewals, consider staggering expiration dates to avoid having too many leases expire in the same year. Additionally, your company should track lease expirations carefully and begin renewal discussions with tenants well in advance of expiration dates. Lenders will view a property with a history of successful lease renewals more favorably than a property with a history of tenant turnover.
Project Future Income Based on Accurate Rent Increases
Leases typically include rent escalation provisions that increase rent over time. These increases might be fixed – for example, 3% annual increases – indexed to inflation – for example, increases tied to the Consumer Price Index – or based on percentage rent – for example, a percentage of your tenant’s revenue. Lenders carefully evaluate rent escalation provisions in leases because they affect the property’s projected cash flow. For instance, when evaluating rent increases lenders distinguish between contractual increases specified in the lease and market increases that might occur if the lease is renewed at current market rates. Lenders are generally comfortable with contractual increases because they’re guaranteed by the contract. They are more skeptical about market increases because they depend on market conditions at the time the lease is renewed.
Your company should ensure that lease escalation provisions are clearly documented in the rent rolls and in the actual lease documents. If your company’s leases include percentage rent provisions or other complex escalation formulas, you should document them and provide explanations to the lender. Additionally, your company should be prepared to justify any aggressive rent increases. If your company is projecting 5% annual rent increases but market rents in your area are only increasing 2% annually, the lender will pose some hard questions and if you don’t have satisfactory answers it may adjust your company’s rent projections downward.
Beware of Co-Tenancy Clauses that May Undermine Your Property’s Value
Many commercial leases, particularly in retail properties, include co-tenancy clauses that give tenants the right to terminate or reduce rent if certain other tenants leave the property or if the property’s occupancy falls below a certain threshold. These clauses reflect the reality that some tenants depend on other tenants to drive traffic to their stores or create a desirable tenant mix. Co-tenancy clauses create risks for lenders that are difficult to quantify because they can trigger somewhat unpredictably a cascade of lease terminations or rent reductions. For example, if an anchor tenant leaves a shopping center, co-tenancy clauses might allow other tenants to terminate their leases or reduce their rent. This could cause your company’s rental income to decline dramatically, making it difficult for your company to service its debt.
Lenders view co-tenancy clauses with great concern because of the uncertainty they create, and will carefully evaluate their scope and impact on your property. When a lender evaluates your company’s property it will identify all co-tenancy clauses and assess the likelihood that they’ll be triggered. If the property has broad co-tenancy clauses that could be easily triggered, lenders may reduce the property’s valuation or impose stricter underwriting conditions and increase borrowing costs.
Your company must understand the details of all co-tenancy clauses in your property leases and should understand the contractual and market circumstances that could trigger them. When your company is negotiating new leases, consider limiting co-tenancy clauses or making them more difficult to trigger. For example, you might negotiate a co-tenancy clause that only applies if a specific anchor tenant leaves rather than a clause that applies if any tenant leaves. Additionally, if your company’s property has problematic co-tenancy clauses in certain legacy leases, you should consider negotiating with the tenant’s amendments to those leases to make the clauses less onerous.
Termination and Expansion Rights Can Affect Lease Stability
Beyond co-tenancy clauses, lenders evaluate all of the termination rights included in your company’s leases. These might include renewal options, expansion options, termination for convenience clauses, or other provisions that allow tenants to exit the lease early or modify their space.
Renewal options give tenants the right to renew their leases at the end of the initial term, typically at market rates or at rates specified in the lease. Lenders generally view renewal options favorably because they give tenants incentive to stay in the property and to pay rent on time. However, lenders will evaluate whether renewal options are at market rates or at below-market rates. If your company’s leases include renewal options at below-market rates, lenders may assume that tenants will exercise the options and may project lower future rental income.
Expansion options give tenants the right to lease additional space in the property. Lenders view expansion options as generally favorable because they may indicate tenant satisfaction and commitment to the property. However, lenders will evaluate whether expansion options are at market rates and whether the property has sufficient available space to accommodate your tenants’ desires to expand.
Termination for convenience clauses allow tenants to terminate their leases early, typically by paying a termination fee. Lenders view termination for convenience clauses with concern because they create uncertainty about future rental income flowing from your property. If your company’s standard leases include broad termination for convenience clauses with low termination fees, lenders may assume that tenants will terminate early and may project lower future rental income from the property.
Your company should carefully evaluate all termination rights in your property’s standard leases. When negotiating new leases, consider limiting termination rights or requiring higher termination fees. Additionally, your company should track which tenants have renewal options, expansion options, or termination rights, and should be prepared to discuss these tenants, and the risks of triggering these provisions, with potential lenders.
Operating Expense Provisions: Clarifying Cost Allocation
Commercial leases typically allocate operating expenses between landlord and tenant. Some leases are “triple net” (NNN), meaning the tenant pays rent plus all operating expenses, property taxes, and insurance. Other leases are “gross” or “modified gross” meaning the landlord pays some or all operating expenses and the tenant pays only base rent. Still others leases are “percentage rent” leases, where the tenant pays a percentage of sales revenue in addition to base rent.
Lenders carefully evaluate operating expense provisions because they directly affect the property’s net operating income (NOI), which is the foundation for most lender’s underwriting calculations. Since NOI also drives key underwriting ratios such as the debt service coverage ratio (DSCR), lenders closely scrutinize expense allocations. If your company’s leases are triple net, the property’s NOI will be higher because tenants absorb operating expenses. That’s good. If your leases are gross, the property’s NOI will be lower because your company pays some or all of those expenses. That’s not good.
When evaluating your company’s property, lenders will normalize operating expenses to account for variations in actual expenses. Normalizing a commercial property’s operating expenses means adjusting actual costs to reflect typical or market driven costs. This is done by removing one-time unusual or owner-specific expenses – like owner’s discretionary spending or inflated salaries – and adding back necessary market-rate expenses – like fair market rent if the owner occupies the space – to show the property’s true sustainable earning potential for valuation or comparison purposes. Normalization creates apples-to-apples comparisons by showing what expenses should be rather than what they were. Lenders will examine your company’s historical operating expenses and project future expenses based on industry standards and market conditions. If your company’s actual operating expenses are significantly higher than industry standards, lenders may adjust their projections upward, which could reduce your property’s value and the loan amount your company can obtain on that property.
Your company should ensure that the operating expense provisions are clearly documented in the rent rolls and in the actual leases. You should maintain detailed records of actual operating expenses and be prepared to explain any variations from industry standards or actual market conditions. If your company’s operating expenses are higher than average, you should be prepared to justify the increases due to, for example, higher property taxes, one-time assessments or insurance costs in your area.
Verifying Lease Terms is Key to Securing Financing
Lenders don’t rely solely on the rent rolls. They typically conduct a thorough lease audit, comparing the rent rolls to each actual lease to the company’s bank statements to confirm revenue is actually booked. This audit serves several purposes. It verifies that the rent rolls are accurate and complete. It identifies any lease provisions that might affect adjustments to or collection of rents, which could impact the property’s value and the lender’s risks. It ensures that all leases are properly executed and enforceable.
Your company should be prepared to provide copies of all leases to the lender. Additionally, your company should ensure that all leases are properly executed and that your company has maintained accurate records of all lease amendments, modifications, and renewals. If your company is missing lease documents or if lease documents are incomplete or poorly organized, the lender may lose confidence in your company’s information and require additional verification or impose more stringent underwriting conditions.
Conclusions
Lease review is a critical component of commercial real estate underwriting, and lenders evaluate leases in meticulous detail. Your company’s rent rolls, tenant creditworthiness, lease expiration schedules, rent escalations, co-tenancy clauses, termination rights, and operating expense provisions affect how lenders evaluate your property and what financing terms your company can obtain.
By understanding how lenders evaluate leases, your company can structure leases more strategically, negotiate with tenants more effectively, and present your property in the strongest possible light to potential lenders. The key is to view lease management not as a routine administrative function but as a critical component of your company’s overall real estate and financing strategy.
About Finkel Law Group
Finkel Law Group, P.C., with offices in San Francisco, Oakland, and Washington D.C., has almost 30 years of experience helping clients navigate complex commercial real estate transactions, including negotiating and reviewing commercial leases, structuring lease provisions to optimize financing, and managing the legal aspects of lease disputes and renewals. Our attorneys regularly assist businesses, property owners, and investors in understanding lease provisions, negotiating favorable lease terms, and ensuring that leases support their financing objectives. When you need intelligent, insightful, conscientious, and cost-effective legal counsel to assist you in negotiating or reviewing commercial leases or managing your real estate portfolio, please contact us at (415) 252-9600, (510) 344-6601, (202) 771-2008, or info@finkellawgroup.com to speak with one of our commercial real estate attorneys about your matter.