Prospective Tenants often question the reason that a Landlord wants to review their financial situation when they are considering leasing space. Prospective Tenants sometimes feel offended and don’t fully understand the connection between a) their financial statements, b) the amount of the money that a Landlord incurs before a Tenant occupies for Tenant improvement allowance and/or 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.  

Below we will examine the need behind requesting a prospective Tenant’s financials, what might lead to a  Landlord deciding not to lease to a prospective Tenant based on their financial condition, or when a Landlord may seek to make the lease agreement more secure through a larger security deposit (or letter of credit) or requiring a personal guarantee. In addition, we’ll provide some examples of specific situations that we faced at Kenwood. 

When a Landlord requests a prospective Tenant’s financial statements, they are typically looking for 2-3 years of income and expense statements as well as a balance sheet.  Alternatively, tax returns may be provided. 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 Revenues. At first glance, one might think a company with this level of Revenues 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 did not agree, but ultimately posted the full 12-month deposit. About three years later, the company filed for bankruptcy and having the 1-year security deposit enabled the Landlord to recoup its initial costs.

When Kenwood reviews a prospective tenant financial position, we are typically trying to evaluate and answer the following:

  1. How has the business performed by reviewing both Gross Revenues, Net Income, and Profit Margin and comparing these items over time?  Are these figures increasing, decreasing or relatively flat?

  2. What could cause financial stress on the company, aside from just an economic downturn?

  3. 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, and then that company suddenly loses that contract. How would the company survive?

  4. How much short- and long-term debts do the company have and how have these changed over time? What was the reason the company incurred the debt (i.e. expansion to service new customers)? Lastly, what if interest rates suddenly increased, would the company be able to pay its debt service?

  5. Are Accounts Receivables growing or shrinking? What is the company doing to reduce its accounts receivables? 

  6. 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 limited operating history?

  7. Is the owner funding the business through personal loans? Will that continue?

  8. 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)?

  9. How much-retained earnings are there?  Has there been a steady growth in retained earnings?

  10. 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?      

During the tenant screening report, unexpected items may also become identified. For example, I once reviewed a regional company’s balance sheet and discovered that the business had been underfunding their defined benefit retirement plan. Kenwood addressed this issue by requiring the Tenant to post a 10-month security deposit. In fact, a few years after the Tenant’s 7-year lease expired, the company filed for bankruptcy.

Landlords will also compare how much rent a prospective Tenant is currently paying to the amount the Tenant would owe under the new lease. If there is a significant increase, Landlords will want to understand how that increase will be handled. An acceptable answer would be that there is a new client or contractual relationship which will more than cover that additional cost.

A Tenant 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, then the Landlord will not recoup its upfront investment. Rent payments are not simply a number that is based on whatever the Landlord can achieve. There is typically a minimum amount that a Landlord needs to charge to cover its basic costs - which would 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, a Landlord should be asking itself – why to pursue the lease at all!

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, or not pursue a rental agreement. A personal guarantee may sound scary to potential Tenants, but if a business is fully committed to its business, and doing your 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 time. It does also show a real commitment to 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.

At Kenwood, we are here to work closely with prospective Tenants for our portfolio and the more than 185 Tenants who currently lease, occupy and enjoy our properties.  Please let us help you.

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