Until about 18 months ago, New York City office building owners didn’t have to worry too much about their tenants’ ability to pay rent. For financial service companies, law firms and retailers, the money was flowing in and their demand for space was strong.
Now, of course, the picture is different. Pillars of the American economy — from AIG to General Motors — have collapsed, and it’s difficult for landlords to discern which tenants are truly creditworthy.
“The question is: ‘What [is] good credit?'” asked Frank Mancini, executive managing director of Grubb & Ellis. “A year ago, AIG was much more creditworthy. A lot of millionaires had good credit until Bernie Madoff came along and impoverished them.”
Building owners and their leasing brokers can perform due diligence on prospective commercial tenants, especially publicly held companies. “Sophisticated landlords will have an in-house risk manager, COO or dedicated financial team looking at the audited financials of an established company and the business plan, track record of personnel and pro-forma earnings estimates of a new company,” said Cynthia Wasserberger, managing director at Jones Lang LaSalle.
For smaller and medium-size companies, landlords must take it a step further and look at the personal finances of the potential tenants as well, said Jake Harrington, director of business development for On-Site.com, which helps landlords screen tenants in New York City. “These guys generally have their personal and company finances intermingled,” he said.
However, in this economy, there’s no guarantee that today’s Google won’t turn into tomorrow’s Lehman Brothers. Whatever the screening process, “a lot of things happened in 2008 that were unforeseen,” Wasserberger noted. “Hopefully we can use that as a learning experience, but there is no crystal ball.”
When financial firms — from commercial banks to hedge funds — were flying high, it made sense for landlords to regard these firms as their strongest tenants.
“There is a reason why tenants with investment credit [typically insurance firms and investment banks] didn’t pay security deposits,” Wasserberger said. “Whether that changes is something that will be looked at.”
There is, however, one huge factor preventing landlords from tightening their standards when it comes to who they’ll accept as tenants: Demand for commercial space is slipping fast. Manhattan office vacancies rose to 7.6 percent in the fourth quarter, the highest rate since 2004, according to data from CB Richard Ellis.
“Two things have changed,” said David Hoffman, executive managing director for Colliers ABR. “First, landlords who are potentially in distress will be less choosy — to the extent their lenders will let them. Second, tenants have more leverage to drive down their security deposits and letters of credit more quickly.”
Case in point: “I just did a deal where a tenant negotiated an accelerated burn-down of their security deposit,” Hoffman said.
Some building owners have turned desperate. And, there is an irony in that at the very point landlords would like to more closely scrutinize tenants, they have every incentive to loosen their standards.
“For certain properties, it almost doesn’t matter what the credit is,” Grubb & Ellis’ Mancini said. (He and others interviewed for this story generally declined to discuss specific buildings, owners or tenants.)
To be sure, landlords do have several ways to protect themselves. “When you feel that the tenant has some type of problem that would restrict their ability to perform, sometimes you avoid putting as much money into a deal,” said Brian Waterman, executive vice president of Newmark Knight Frank.
“Sometimes you ask tenants to fund improvements themselves, or ask for a greater security deposit, or reduce a concession package. There are multiple ways you can reduce your exposure.”
Landlords who are afraid that a tenant may go bankrupt often ask for a letter of credit rather than a standard security deposit. That’s because a company’s bankruptcy may allow it to avoid forfeiting a security deposit but doesn’t affect the obligation of its bank to pay out a letter of credit.
However, in these perilous times for the financial sector, even that’s not a surefire strategy. What if the bank issuing the letter of credit goes belly-up? “I still haven’t received a clear answer on that one,” Hoffman said.
It’s worth noting that not everyone views a 7.6 percent vacancy rate as cause for panic. “There are some big companies getting hurt, but thousands of firms are making profits,” said Norman Sturner, managing partner for Murray Hill Properties, which owns 5 million
square feet of office space in Manhattan.
Even for companies experiencing financial difficulties, “unless they are in bankruptcy proceedings, a lease is a lease,” he points out.
“They have to pay rent.”
General Motors offers a perfect example. “They’re one of our tenants, and they’re paying their rent. I don’t worry about them,”
Sturner said.
He’s not about to shy away from other companies in the industry, either.
“There are plenty of healthy automakers,” he said. “If Volkswagen or Ferrari walked in tomorrow, I’d welcome them with open arms.”
Still, Murray Hill has loosened its standards a bit. “In this kind of market, a lot of the time you take chances on tenants that might not be as financially strong as you like,” Sturner said. “But perhaps they’re willing to put up a major security deposit, with a burn-down over time. We do a lot of financial engineering.”
It’s all about trade-offs, said Wasserberger of Jones Lang LaSalle.
“Landlords are spending more in this market on customized space and free rent,” Wasserberger said. “Concession packages have gone up. We can be aggressive in structuring deals, but we need to be fiscally conservative in how we secure them.”
While landlords will take rent checks from whence they can get them, they will be leery of financial services and law firms, some of which also have struggled during the financial crisis, Wasserberger said.
“Landlords may look at financial firms and law firms a little differently now, and are less likely to take what they say at face value,” he said. “For example, how likely are private equity firms to raise funds?”
Still, thanks to the financial crisis, tenants have moved to the catbird seat.
“Right now it’s more of a tenant’s market,” Mancini said. “When the real estate market is tighter, landlords can demand more. But now, if a landlord wants a guarantee, a tenant can just go down the block and not give a guarantee.”