Illustrations by Roberts Rurans
The COVID-19 pandemic has shone a spotlight on the many ways businesses are run. In real estate for example, attention has turned to income, the backbone of the sector. Everything in property hinges on investment value, and how tenants pay their rent, from the length of the lease to the quality of the income itself.
There is just under $1.5tr of rent that commercial real estate tenants around the world expect to pay this year. Given the effects of the global pandemic on that fixed income-style investment, it is more important than ever for the commercial property sector to understand the tenant and their circumstances.
This is particularly prevalent in areas of the market where landlord, lenders and investors are facing a growth in operating risk. The question is how risk income is monitored. Not only that, but how it is rated and analysed, and which are the best tools and data to use.
“We use Creditsafe and Dun & Bradstreet to assess credit risk and these are widely accepted by the market,” says Peter O’Brien MRICS, MD of real estate advisor Avison Young. However, he says one issue is the data is sometimes out of date and depends on the last set of accounts for the tenant.
“Ideally there would be a way of assessing credit risk in a more up-to-date format, but this would involve all companies reporting their financial strength on a more regular basis,” says O’Brien.
Matthew Richardson, co-founder and chief executive of Income Analytics, believes the industry needs to move away from looking at relative credit ratings and subjective labels, and focus instead on failure data, mapping what’s happened and how often companies go bust.
“That’s the key metric for us,” said Richardson in Income Analytics’ Incans Risk Insight report. “By doing that we can begin to build out and start looking at things like forward projections of data.” Richardson says other instruments can be mapped, whether they be debt or equity instruments and begin to express potential loss in cash terms, “which is ultimately, as an industry, where we want to be.
“We need to bring ourselves into line with the other competing asset classes and try and get a place at that table by providing the kind of metrics and transparency investors are used to seeing in the bond and debt markets,” he adds.
The question is to what degree the valuation industry should take income into account, versus a pure look at capital values.
“They go hand in hand,” says Charlotte Aschan MRICS, director of valuation at Savills. Aschan, who also contributed to Incans Risk Insight report, says the quality of the income stream is needed to pay the loan, but the fundamentals of the property are also needed. “With short leases, our valuation is becoming much more explicit in terms of what happens if the tenant breaks it, or if the expiry is quite short-term.”
It’s less about pricing in the yield than being clear in the valuation process, says Aschan. But she adds: “If you haven’t got a tenant paying the rent, it will hit the whole income stream. For us, it’s always been quite a subjective process looking at the covenant strength. We look at what’s going on in the press and tenants’ reports in accounts. But equally, we’re not chartered accountants – we’re not qualified to do that.”
O’Brien believes there are lessons to learn about carrying out risk assessments more often. The situation, he says, mirrors some aspects of how the industry was affected during the 2008 global financial crisis. “In any time of crisis, regular assessment of the credit worthiness of the tenants is needed.”
The sector is now seeing shorter leases and mobile tenants, so which matters more – a good tenant, quality of the building, or location? They all matter, says O’Brien. “If one of those is of poorer quality then the property is not going to be as resilient to market fluctuations when compared to a property which is strong in all three aspects.
O’Brien adds: “In a boom market this not the case and a property can perform well when one of those criteria is of poorer quality, but when we are in the middle of a pandemic all three matter just as much as each other.”
She believes the days of signing a lease and putting it in a draw for the next 20 years are long gone, and those in the industry need to be on top of what’s happening, “and we, as lenders, are part of that as well.”
As the world adjusts to the changes of the last couple of years, the way tenant credit risk is assessed will change too. More than two-thirds of global wealth is held in land and property assets, and much of global bank lending secured on these assets. How valuers work will play a vital role in supporting markets by creating consistency and transparency.
“In any time of crisis, regular assessment of the credit worthiness of the tenants is needed” Peter O’Brien MRICS, Avison Young