As of the end of June, commercial real estate is the second largest credit risk on community bank’s balance sheets, composing almost 29% of the loan portfolio - just slightly behind residential real estate exposure. On a dollar basis, we are now approaching some of the highest levels in history and are on track to break the record in the next year, a record set back in Dec, of 2008. Within commercial real estate risk, tenant quality and lease rollover are some of the largest single risk factors that banks are exposed to and it just so happens that the number and quality of leases expiring is set to peak again around 2017.
To help manage this risk, we gathered a group of bankers that have successfully navigated the downturn, real estate investors and REIT managers to learn the best practices when it comes to analyzing lease rollover risk. Having a clear framework to evaluate and manage this risk can help avoid problems and ensure the proper allocation of management resources. Of course, lease expirations are not always a bad thing. For example, in hot markets, commercial building owners have little trouble rolling existing tenants or finding replacement tenants. However, maturing leases often increase risk by increasing tenant improvement cost, lease brokerage expense and creating vacancies which directly hurt cash flow.
To analyze lease rollover risk, there are just a couple factors that statistically matter. While most bank credit managers understand that the larger the positive difference is between current rent and market rent , the lower the risk, many bankers don’t have a feel for the extent of this risk and how to analyze this risk on a forward looking basis. In general, current lease rates that are at or within 10% under market have a 65% chance of renewal in today’s market. For every 10% difference, the probability of a renewal changes by about 18%. Thus, if the current lease is 20% below market, the chances of renewing that lease is 83%.
Of course, this factor varies depending the type of property, the availability of other comparable properties and the cash flow growth of the tenant. Industrial properties, for example, are more volatile as are retail, while multi-family is less so. The smaller the market, the more volatility and the greater the risk of non-renewal. Another rule of thumb is that the greater the cash flow growth is of the tenant the greater probability that they will not renew as the current property may not accommodate the growth.
To give a sense of the higher costs associated with lease renewal; the average community bank applies between $7 and $25 per sq. ft. for new tenants and $1.50 to $10 per sq. ft. for renewals for suburban class B office (the most common asset class) to take care of tenant improvements. In addition, community banks are currently applying about 2% leasing commission for renewals and 4% for new tenants.
To predict where rents will be in the future, bankers start with current rents, then look at construction new supply coming on line and the current absorption rate. If new supply is 15,000 sq. ft. a month for the area, but absorption is 20,000, bankers can expect rents to remain stable or improve. The converse is also true and must be taken into account when predicting the probability and costs associated with lease expirations.
For major tenants, it also pays to tag any abnormalities in the leases to better get a picture of renewal risk. Unfortunately, few properties of age have boilerplate leases and bankers often find odd ball clauses that impact (positively or negatively) rollover risk. Purchase options, the right to adjacent space, new tenant improvements every year and even tenant ownership of certain improvements can impact the probability and cost of renewal. Understanding the owners or management company strategy for dealing with these clauses can also help predict potential vacancy rates, rents and tenant replacement costs.
Finally, there is a group of intangible factors that banks should understand about the property. These items are normally gathered during annual property inspections or interviews, but they should be tagged and at the ready for an analyst to quickly pull those factors from the credit file that could impact lease renewal rates. Problem tenants, insurance claims, environmental changes, traffic adjustments or zoning issues all play a role that a good banker will monitor and manage. At the time of recording, the credit administer should market if the changes are material and if they are positive or negative towards tenant renewals and ultimately, property values.
At least once per year, when property cash flow projections are updated, lease renewal assumptions and costs should be reviewed and modified to reflect the current state of the market and the current state of the property. By keeping up to date on the lease rollover risk and impact to the property, bankers can often have an early warning signal to assist the borrower BEFORE there is a problem. Now that we are getting back to record commercial property asset prices and that we have a record amount of leases coming due, now is the time to devote more resources in order to limit credit risk associated with lease expiration.
Submitted by Chris Nichols on July 22, 2014