Why Lenders Should Assess The Tenant Health Ratio

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Checking Up on Tenant Health is A Vital Sign in Risk Assessment

Much like taking temperature is a simple measure to evaluate a patient’s health, a tenant health ratio is a meaningful metric to use when diagnosing whether an occupant will be able to make payments, turn a profit, and/or renew a lease. Historically, the ratio has been looked at more often by landlords and commercial real estate investors, but lenders would do well to consider the viability of potential tenants just the same.

A tenant health ratio, or occupancy cost ratio, is calculated by dividing the total annual rent by the gross annual sales. Total annual rent will also include costs such as CAM reimbursements, tax reimbursements, and rent percentages. It’s important to remember that this rent-to-revenue percentage is location specific, and not based on an average if the tenant has multiple locations.

And it’s relatively easy to obtain this information.

Most leases require that tenants report their gross annual sales at a given location for two reasons:

  1. Some leases include rent percentage clauses
  2. It helps the landlord take the property’s economic pulse

So, what figure indicates a ‘healthy’ health ratio? It depends on the sector. For low-margin businesses such as grocery stores, 2% or less is often a perfectly acceptable percentage, whereas luxury retailers who are able to generate higher sales per square foot will be fine with ratios closer to 15%. But generally, a lower health ratio represents a lower risk.

While there are, of course, exceptions to the rule, here are the typical ranges in some common retail categories:

Grocery stores 1%-5%
Restaurants 5%-8%
Apparel retailers 10%-15%
Fitness centers 15%-25%

Another useful metric is Tenant Sales Per Square Foot (Tenant Sales PSF). It is exactly what it sounds like––the annual gross sales are divided by the square footage of a given location.

Lenders who need to evaluate a deal that has no current tenants can approximate potential sales through several different avenues:

  1. Analyze key anchors such as Target, Starbucks, and Panera that draw traffic and sales
  2. Use retail void analysis reports
  3. Segment demographic data
  4. Interview existing tenants in similar markets

Once the data is gathered and the calculations are complete, decision makers still need to take into account other factors to determine whether the ratio is typical, good, or walk-away bad.

For instance, CRE lenders should look at the tenant’s potential for growth and how critical that particular tenant is to the success of the total property. Sales PSF of an anchor are going to be more important than sales or occupancy cost ratio of a smaller retail tenant.

There are resources to help determine the values of good and poor for the various types of investments. Green Street provides reports and other analyses for the markets they track, and Korpacz Realty Advisors publishes a yearly analysis of regional malls. Additionally, REITs will often include sales information and cost of occupancy data in their investor materials.

When examining deals, a tenant health ratio is a basic diagnostic tool to use during risk assessment. It’s relatively simple and can give lenders more insight into the project’s picture of financial health.

In addition to its powerful deal matching algorithm, Finance Lobby accurately compiles property data on what’s rented, what’s vacant, rentrolls and income, and other key details. Just another way Finance Lobby empowers lenders to rapidly assess risk the instant a potential match is sent.

January 18, 2021