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How Lease Agreements Can Protect Against Risk in Single-Tenant Office Assets

There’s advice experts can offer borrowers on structuring leases to help protect their interests if something goes wrong.

Single-tenant office buildings present a greater risk for loan default than multitenant assets because the sole income stream is dependent on one tenant. But there’s advice experts can offer borrowers on structuring leases to help protect their interests if something goes wrong.

In recent years, there has been a rush by investors to acquire single-tenant office buildings, because this type of asset offers better yields than Treasury bonds, says Eric Entringer, vice president of capital markets and investor relations at Dornin Investment Group, a real estate investment firm with offices in Orange County, Calif. and Las Vegas.

He notes that these assets are attracting lots of 1031 exchange investors, as well as investors pulling out of the stock market, but suggests a question they should ask themselves before investing in single-tenant office assets: “Is the risk appropriate in terms of the returns they’ll get over Treasury bonds?”

Moody’s Investors Service reported recently that increasing competition among lenders has caused them to loosen underwriting standards and increase non-recourse carve outs, raising the risk of default in the CMBS loan market, including for loans on office assets occupied by only one tenant. The report notes that roughly 80 percent of these assets are now occupied by tenants with no credit rating.

Mark Nicoletti, a Los Angeles-based real estate attorney with the law firm Sklar Kirsh, notes that major, credit-rated companies rarely lease small, stand-alone office buildings, so it stands to reason that many of these buildings would be occupied by non-creditworthy tenants. What makes these assets so volatile compared to multi-tenant office assets, Nicoletti points out, is the fact that the revenue stream is dependent on the success of just one tenant.

In today’s market, “loan deals on single-tenant buildings ride on underwriting the lease agreement,” he says, noting that a lease needs to contain protections against a tenant’s default that cover any added expenses to re-lease the property. The lease also needs to cover payment of the landlord’s debt service while the building is vacant, “because whether or not the tenant pays, ‘whatever warm body’ the lender underwrites is not getting out of the deal,” Nicoletti warns.

Since one tenant is the sole source of the landlord’s income, Entringer emphasizes that structuring the lease agreement should focus on the tenant’s ability to pay for real estate for the term of the lease. To do this, he says, the landlord must understand the tenant’s business plan, profitability, balance sheet and how the property fits into the firm’s overall business strategy. Is it an ancillary site or company headquarters? Where does the tenant’s income come from?

Entringer uses the example of a company leasing a building near its headquarters. If the landlord understands that the company is in the process of building a new corporate campus or expanding its original campus, then the landlord can expect the company will only occupy the building until its new campus is completed, especially if the company has not invested much money in tenant improvements (TIs).

He notes that one way to ensure the landlord is “more protected is if the tenant has a significant amount of ‘skin in the game.” For instance, “If a company signs a five-year lease and then puts $50-$100 per square foot into TIs themselves it will more likely renew at the end of its initial term.”

“The most important thing, however, is the right entity signing the lease,” Entringer notes. “Is it the parent company or a subsidiary signing the lease? If [it’s] a shell company, how does this building fit into the parent company’s business strategy, and will the parent company guarantee payment of rent for the term of the lease?”

“If this is a long-term lease with an early termination option, the landlord needs to include some sort of early termination penalty in the lease agreement,” he adds, noting that this typically includes amortization of the TI allowance, free rent and leasing commissions. Entringer notes that the landlord should try to get a termination penalty that covers a portion of the new marketing costs, TIs and leasing commissions, as well as compensation to buy time to re-lease the building. 

According to Nicoletti, the security deposit can be used to cover debt service for a sufficient period of time to re-lease the building if the tenant defaults. But while most owners of smaller office buildings tend to prefer cash deposits, he notes that a cash security deposit does not protect against bankruptcy because it becomes part of the bankrupt estate.

He, therefore, recommends that a security deposit be in the form of a letter of credit, which is an agreement between the bank issuing it and the landlord and so does not become part of a bankrupt estate.

TAGS: Lending News
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