Prospective Commercial Tenants: Why Reviewing Financials Is Necessary
Published January 23, 2020. Updated September 14, 2023.
Prospective tenants often question why a landlord or our commercial property management team wants to review their financial situation when considering leasing business space in one of our properties.
Business owners sometimes feel offended and don’t fully understand the connection between a) their financial statements, b) the amount of the money a landlord incurs before a tenant occupies for tenant improvement allowance and leasing commissions, and c) the tenant’s security deposit.
Moreover, many tenants simply assume that landlords universally charge a one-month security deposit to all tenants, even a brand-new business with no operating history.
So, today, we examine the need behind requesting a potential commercial tenant’s financials, what might lead to a landlord deciding not to lease to a business based on their financial condition, or when a landlord may seek to make the lease agreement more secure through a larger security deposit, letter of credit, or by requiring a personal guarantee. In addition, we’ll provide some examples of specific situations we faced here at Kenwood Management.
Why We Request Your Financials
When a landlord requests a prospective tenant’s financial statements, they typically look for 2-3 years of income and expense statements as well as a balance sheet. Alternatively, tax returns may be provided in response to the request for business financials.
The goal is to understand the health of the tenant’s business. Financials can be challenging to understand, but they can also be very insightful. Sometimes, they can require a detective-like approach to evaluate.
For example, I once reviewed a large privately held tech company’s financials that showed over $1 billion in annual gross revenue. At first glance, one might think a company with this level of revenue and a national platform would be an excellent credit tenant and might not be required to post any security deposit with the rental application.
However, by digging further into the corporation’s financial statements, it became clear that the company was spending in excess of $1 billion in expenses via research, development, and expansion. I required the company to post a security deposit equal to 12 month’s rent. This national credit tenant initially disagreed but ultimately posted the full deposit.
Then, about three years later, the company filed for bankruptcy. Having the one-year security deposit enabled the landlord to recoup its initial costs.
What Do We Evaluate When Reviewing Commercial Tenant Financials?
When Kenwood Management reviews a prospective tenant's financial position, we are typically trying to evaluate and answer the following:
How has the business performed by reviewing Gross Revenues, Net Income, and Profit Margin and comparing these items over time? Are these figures increasing, decreasing, or relatively flat?
What could cause financial stress on the company, aside from an economic downturn?
How many clients does the company have? Does any single client account for a significant portion of the company’s Gross Revenues? Imagine a company that only had one client, such as a single government contract. Then, that company suddenly loses that contract. How would the company survive (and continue paying rent in their commercial space to rent)?
How much short- and long-term debt does the company have, and how has it changed over time? Why did the company incur the debt (i.e., expansion to service new customers)? Lastly, if interest rates suddenly increased, would the company be able to pay its debt service?
Are accounts receivables growing or shrinking? What is the company doing to reduce its accounts receivables?
How many years has the business been operating, and what experience does the owner(s) have in operating this business? Is it a start-up with a limited operating history?
Is the owner funding the business through personal loans? Will that continue?
How big is the owner's salary? Is that salary typically sufficient to live on (if not, why would the owner continue to keep the business open)?
How much retained earnings are there? Has there been a steady growth in retained earnings?
How much cash does the business have readily available? Is it sufficient to cover the costs of relocating the business to our building or, for a new business, to purchase furniture, inventory, computers, and payroll?
Answers to these questions give our commercial property management team good insight into the sustainability of a potential business tenant as a good addition (or not-so-good choice) for space in one of our properties.
We Uncover Unexpected Information
During the tenant screening report, unexpected items may also be identified.
For example, I once reviewed a regional company’s balance sheet and discovered that the business had been underfunding its defined benefit retirement plan. Kenwood addressed this issue by requiring the tenant to post a 10-month security deposit. Then, a few years after the tenant’s 7-year lease expired, the company filed for bankruptcy.
We Compare Rent Amounts
Landlords will also compare how much rent a prospective tenant currently pays to the amount the tenant would pay under the new commercial lease agreement.
If there would be a significant increase when renting one of our commercial spaces, we will want to understand how that increase will be handled. An acceptable answer would be that the business has a new client or contractual relationship that will more than cover that additional cost.
It's Not Unlike Applying for a Bank Loan
You may be thinking that all of this analysis and evaluation is no different than if you were seeking a bank loan — and you would be correct in that thinking.
Underwriting a tenant for a lease is very similar to being evaluated for a bank loan. The reason is simple: in most cases, a potential landlord is making a considerable payment upfront to cover tenant improvement costs and leasing commissions. The landlord plans to be paid back for these costs over the lease term through the rent payments.
If the rent payments are interrupted, the landlord will not recoup its upfront investment. Rent payments are not simply a number based on whatever the landlord can achieve for a commercial space.
There is typically a minimum amount that a landlord needs to charge to cover its basic costs to cover the building’s operating expenses, the mortgage payment, a return for the landlord’s equity investment in the property analysis, amortization of the tenant improvement allowance, and leasing commissions, real estate taxes, and insurance. If these items aren’t being covered by a commercial tenant's monthly rent amount, a landlord should be asking, "Why pursue the lease at all?"
What Happens After Reviewing Financial Information from Commercial Tenants?
If all of the numbers look good, the business history supports longevity, and the answers to the questions above indicate the potential for a long-term future with a thriving business, in most cases, a landlord will approve commercial tenants for the space they want to rent. The lease negotiation process begins!
However, when a landlord has concerns about a prospective renter's ability to meet its rental obligation, there are generally three options a landlord would consider:
Insist upon a large security deposit
Require a personal guarantee from the prospective tenant (not unlike something a bank would request for a business loan)
Not pursue a rental agreement with the business for the space
A personal guarantee may sound scary to potential tenants. Still, if a business is fully committed to its business and doing its due diligence to ensure that it won’t fail, then it can reduce the potential of a larger cash security deposit (or letter of credit), which will tie up funds for some period of time. It also shows a real commitment on the tenant’s behalf.
A personal guarantee can also be reduced over time, based on a tenant’s financial strength with on-time rent payments and no acts of default under the lease.
Kenwood Wants Commercial Tenants to Thrive In Our Properties
Our goal when reviewing tenant financials is to match businesses to the ideal spaces and ensure they can cover the costs of the space while their company operates successfully. If we choose a tenant for a space, but the financial documentation doesn't show a history (or future) of success, that's not helpful for their business, either! That's why we work hard to deliver buildings and commercial leases with the best terms to help businesses thrive.
At Kenwood Management, we are here to work closely with prospective tenants for our portfolio of properties. If you'd like to learn more about our financial review process or available spaces in any of our buildings, please reach out to our team through the button below. We're here to help!