Can Your Credit Tenant Become Your Primary Risk?
By: Date: March 7, 2021 Categories: forbesrealestatecouncilblog,lifestyle,Real Estate,Uncategorized Tags: , ,

Andy Hochberg is the CEO and Managing Principal of Next Realty, a Chicago-based real estate investment and management firm.

Two retail storefronts available for lease in a strip mall


Commercial real estate investors often employ a strategy to lower asset risk by leasing all or a significant portion of space to a strong credit tenant. Typically, that strategy contributes to predictable cash flow and enhanced property values for investors. In certain assets, that credit tenant can be a driving force generating interest in the property, both from other tenants and the public.

Yet throughout the normal course of business, and particularly during rapidly changing economic conditions, even slight deviations to tenants’ credit standing or strategy can dramatically alter this investment thesis. As a result, during any investment cycle, and perhaps especially in this current pandemic-induced climate, real estate investors must be prepared to answer important questions: 

Can the greatest asset — a strong credit tenant — become a primary risk?

Can you safeguard against risk?

What if shifting risk occurs?

Credit Tenant: Asset Or Risk?

The credit tenant that added to the value and attractiveness of an asset can become a primary risk. Reasons that could occur include:

• Industry-centric changes: Industries constantly evolve and change due to outside forces. For example, the pandemic has devastated certain industries such as travel, fitness and movie/entertainment experiences. The financial toll may be readily apparent, or we may be waiting for the other shoe to drop. Ongoing evolution in an industry can also have a significant financial or operational impact on a business from a financial or operational perspective.

• Company-centric changes: The types of changes a company may experience are endless. Undertaking aggressive expansion efforts can be a significant drain on capital. Companies may merge, be acquired or be infused with debt that changes their financial situation. Further, there may be additional and new competitive pressures present that trigger an operational issue and have a financial impact.

• Lease term: An owner can’t take anything for granted, including the anticipated certainty of a lease renewal. Tenants today have greater opportunities to relocate operations and reduce occupancy costs. The impact to a property’s value can be considerable if renewal percentages decline and pressure rental rates to move lower.

• Legal challenges: At the start of the pandemic, larger credit tenants took the position that state and municipal closures entitled them to rent relief. Even though most of these tenant positions were unfounded, the lingering threat could create financial uncertainty and put significant pressure on landlords.

Safeguard The Risks Before Investing

In his book The Most Important Thing, investor Howard Marks writes, “Investment success doesn’t come from ‘buying good things,’ but rather from ‘buying things well.’” Buying well mandates that an investor takes nothing for granted while doing the homework. That has never been truer than it is today. The days of being able to “put it in a drawer and forget about it” are gone.

Several years ago, my firm acquired a 133,000-square-foot community center anchored by a national bookstore. While the retailer had strong overall credit, the local store was underperforming. In doing our advance due diligence, underwriting accordingly and establishing strong capital reserves to cover releasing and re-tenanting the space, we protected ourselves and our investors. Further, over the long term, we orchestrated the strategic re-tenanting of the 50,000-square-foot anchor tenant position to an AA-rated hospital healthcare system that produced a 30% increase in net operating income.

This example further supports adhering to the concepts of location, liquidity and luck, which we have been communicating for many years. The precept “location, location, location” is well known. However, I maintain that liquidity and luck have earned a rightful spot next to location in the real estate lexicon. Location matters and cannot be discounted. Yet liquidity — having access to capital — is also critical. And, we can all use a little luck and good timing.

What If?

Buying well doesn’t mean that unforeseen events, like a credit tenant becoming a potential liability, won’t happen and create issues for good properties. A tenant could go out of business, file for bankruptcy, need to dramatically reduce its footprint or find itself in various other situations that increase the potential risk to an asset’s stability. 

Unfortunately, there are no magical, silver-bullet solutions for any of these potential issues. If the significant credit tenant experiences factors that make it a risk, among the most critical and logical steps to mitigate the risk include:

• Assessing property level liquidity to understand the debt service/property tax obligations, needed capital improvements, marketing expenses and operating cash.

• Developing a plan with contingencies for marketing and releasing the space.

• Communicating with stakeholders such as investors and lenders who may be impacted by the situation.

• Being creative, flexible and resourceful to identify, understand and carefully evaluate all options.

While all these steps are important, in today’s business environment, creativity, flexibility and resourcefulness are essential. Being able to think outside of the box may dictate alternative approaches that provide necessary relief.

For example, when a large national retailer with anchor spaces at a number of our properties filed for bankruptcy, we checked all the appropriate boxes related to liquidity, planning and communication. Having a high level of resourcefulness and flexibility allowed us to overcome this situation. At one of the properties, we were able to work with existing tenants to accommodate expansions, relocations and new leases to re-tenant nearly all the vacated space. At another property, we leveraged the asset’s prime location in converting the retail property into a medical office facility. And finally, at a property that originally was developed as an office building before being converted to a single-tenant retail property, we redeveloped the asset into an office property that subsequently was fully leased.

The reality is that you can’t protect against all risks. Unforeseen events do occur, changing the trajectory of the initial investment. With careful planning, it is possible to mitigate, as much as possible, the impact risk can have on a property and a portfolio — and, once in a while, come out ahead.

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