What is Tenant Covenant Strength in Commercial Property?

When we say ‘Tenant Covenant Strength,’ in the context of commercial property and commercial property lettings, we are focusing on the ability of a tenant to comply with the tenant covenants in a commercial lease.

The tenant covenant strength is often a subject of discussion between a commercial property agent and their landlord client when considering a commercial letting offer. The covenant strength is a key reason in a decision making of a landlord when agreeing a new commercial property letting. It can impact on leasing, financing and investing decisions – commercial tenant covenant matters!

A prospective letting is only as strong as the tenant covenant named as tenant (and guarantor if applicable). A 20 year lease with a tenant paying £80,000 pa for a double shop front in Fulham, is fundamentally less risky (and worth more as an investment) if the tenant covenant is very strong / strong than if the covenant is weak / very weak. An investor will generally (all other things equal) be willing to pay more for a stronger tenant covenant.

Why does tenant covenant strength matter for a commercial tenant?

Tenant covenant matters for a commercial property landlord who owns, holds, buys and sell commercial property.

Tenant covenant can impact in a number of ways for a commercial property owner:

• Holding a commercial property with a strong tenant covenant means you are more likely to receive payment of rents and have the tenant covenants of the lease performed.
• It (a stronger covenant) improves the investment value of your commercial property (a stronger covenant will mean a lower yield is applied and a high investment value).
• It can be easier to secure bank lending / finance with a stronger tenant covenant.
• As a landlord, a weaker covenant means you are in a weaker position if issues arise and a tenant wants to re-negotiate terms later into the lease.
• The covenant strength of a tenant is a major reason why a commercial property landlord may let a property to a tenant or not.

Fundamentally a better / stronger covenant as a tenant, provides a commercial property investor with a more attractive investment to hold or potentially sell to the market.

What is strong covenant strength in a commercial property letting?

A strong tenant covenant is subjectively judged in comparison to other potential tenants. A strong tenant in a commercial property transaction is a tenant that is judged to have a high likelihood of fulfilling the lease obligations.

Strong covenants in the commercial property market space are considered to fall into one of the following brackets

– Large multinational corporations

– Government entities

– Established national retailers

– Blue-chip companies

A strong covenant would be able to demonstrate evidence of being able to pay rent and other financial commitments over a long period of time and be financially robust. Often a strong covenant has a reputation in the market and a well known brand. A ltd company may report a very high financial rating and demonstrate a strong balance sheet. An individual may own assets which show a level of financial strength.

Amazon for example would be considered arguably the strongest commercial tenant covenant possible. A strong commercial tenant covenant doesn’t have to be amazon of course, but it is perceived as carrying a lower financial risk.

What is a weak covenant strength in a commercial property letting?

A weak tenant covenant for a commercial property letting is of course as subjective as judging a stronger covenant. If the tenant is of limited financial standing (low /no revenue, profit and net assets), a new business with limited previous trading history then this would be judged as a weak covenant.

A weak covenant will have a higher risk of not performing their lease covenants.

How can a Tenant Covenant be accessed?

Accessing a tenant covenant is a mix of of reviewing objective information and market perception.

• Financial Reporting
• Credit References
• Landlord References
• Brand Exposure
• Financial Asset Checks
• Physical Inspection of Current Business Locations
• Gut Feeling (does the information make sense and sit right with you?)

There is not necessarily an objective way to access such information, as the judgement is made in context of the deal. If you are letting a small starter shop in Wandsworth with a rent of £12,500 pa, as a landlord / landlord agent, you would take a different stance, than if you were considering a 5,000 sq ft new office in West London with a rent of £150,000 pa for example. The context of the deal and the market will dictate how you access a tenant covenant.

What can be done to mitigate a weak tenant covenant risk in a commercial property letting?

The covenant strength of a tenant is a major reason why a commercial property landlord may let a property to a tenant or not.

If a commercial landlord / landlord agent considers the tenant covenant too weak, is that the end of the deal? Possibly, although there are options to mitigate a perceived weak tenant covenant risk, as follows :

1.) Personal / Director / Cross Company Guarantor

2.) Rent Deposit

3.) Rent Up Front

4.) Shorter Lease Terms

5.) More Frequent Break Clauses (for both landlord and tenant)

6.) Contracting Out (no security of tenure)

Commercial tenant covenant – context matters!

When assessing the covenant strength of a commercial tenant, context does matter!

Whilst when assessing any prospective letting, a thorough and rigorous process is always required, the context and specifics of the commercial letting deal matter.

Do you expect 3 years of accounting showing 6 / 7 figures of turnover and net assets for a small shop letting in Romford? No, however for a smaller shop letting as a landlord you would seek commercial landlord references (where possible), carry out checks on individuals (to be named as tenant or director guarantor if a ltd company) and context of the funds available for the business.

For a company that is established with a larger potential rent and lease obligation, you would likely rely on an Experian or Dun and Bradstreet business credit report, last 3 years accounts and landlord references. Such a company is unlikely to offer a personal / director guarantor and therefore you would use different checks appropriate to the deal.

Also, imagine this scenario, say if you have a commercial property such as a shop in Wimbledon and you receive 10 plus good / strong letting offers. Where as if you have a retail unit in Bermondsey that has been empty for 12 months, is in poor condition and you have received one letting offer from a new business with no trading history. Would you take the same stance for both lettings in terms covenant threshold? With the Wimbledon shop letting you are in a stronger position to dictate and ask for stronger terms and checks, than you might otherwise in the letting of the retail unit in Bermondsey.

Although it is never wise to let a commercial property for the sake of it, any checks are in the context of the market and specific deal. Some commercial properties will attract weak covenants and in that case it’s about mitigate the commercial risk as opposed to a perfect deal.

There is a blurring of the lines between small, medium and larger businesses letting checks. There is no one size all check. As the market changes, so do the checks and what is consider standard market behaviour.

Indicators of tenant covenant strength?

Strong: Large cash reserves, long-term profitability, strong bank references, and high tangible assets.
Weak: High rent-to-turnover ratio, limited trading history, low credit scores, or a business in a volatile industry, no previous trading history, limited financial and tangible evidence of trading.

So you can see from reading the above, the covenant strength of a commercial tenant is a fluid and subjective. As the market changes it pays to have a commercial property agent advising the best way to assess and check out a prospective commercial tenant. The decision is more than a balance sheet or just a gut feel! Be smart, use an experienced commercial property agent!

Greater London Commercial can can help find and check out commercial property tenants! Contact Greater London Commercial on 01708 973700 to discuss how we could assist you with our commercial estate agency services.