Five Ways to Reduce Tenant Risk

In the wake of the financial crisis, tenant diversification proved to be as important as geographic diversification—and perhaps more so. But are investors and managers doing enough to spread their tenant bets?

In an era focused on the lessons learned from the global financial crisis, there is equally powerful guidance on tenant diversification to be taken from what happened in 2001.

“In 2001, you had significant defaults from technology tenants. Many real estate holders were very exposed to tenants that had no net cash flow, no tangible assets, were not very profitable and yet had high valuations. Many of those leases went sideways,” says Tawan Davis, chief investment officer for The Peebles Corporation, describing the risks of overexposure that occurred across many markets.

As investors continue to pour money into the real estate asset class, there is a question as to whether the risk mitigation of tenant diversification is fully reflected across investor portfolios. Despite spreading investment dollars across markets and global regions, portfolios may not necessarily be strongly diversified across these lines.

“If you zoom out when you look at the broad portfolios of [investors]—pensions, sovereigns, and the like—they can have thousands of tenants across funds and managers. Given their staff constraints, they don’t always have time to analyze tenant diversification across their real estate portfolio, which probably includes numerous funds managed by separate managers,” observes Piyush Bhardwaj of CoInvestment Partners.

“Tenant diversification can take greater importance than geographic diversification. In another downturn, you might see a greater impact on your benchmark performance if you don’t ensure you have tenants across industries that are countercyclical.”

Given its importance from a risk-management perspective, three property managers and operating partners offered their best practices for achieving greater tenant diversification.

#1 – Avoid Industry Overexposure 

The year 2001 demonstrated how real estate, through tenant overexposure, got caught in the shock waves of an unrelated industry’s bursting bubble. In the rapidly rising real estate market of the past few years, many trophy properties in major markets are heavily comprised of financial services, technology, and other high-growth industries. “If you have portfolio investments in London, San Francisco, Singapore, and New York and they have a tenant roster concentrated within a single industry—for instance, financial services—you are not diversified,” says Bhardwaj. “In another downturn, you will see a greater impact when compared to your benchmark.”

Bhardwaj offers the example of grocery-anchored shopping centers and the impact of industry consolidation. “It means a lot of tenants might roll up into the same parent company. How are you protected against that? When you look at industrial or big-box logistics where you have a few tenants per property, make sure you don’t have the same anchor-tenant concentration across the portfolio,” he says. The same issue can be applied to third-party logistics. “Here is where digging beneath the surface can really help. A portfolio may have the same third-party logistics company as an anchor tenant in two properties, but the tenant could be providing services to two different industries—food-and-beverage and defense.”

#2 – View Tenant Exposures as Dollar-weighted

Many properties that have benefited from recent market conditions are occupied by large anchor tenants. “The value of an investment is dependent on the value of the rent roll,” says Chip Walters, chief investment officer at Keystone Property Group. “If a tenant ceases to pay, then what’s my opportunity for a replacement tenant at the same rent?” He says there is a challenge of measuring the weight of large tenants, along with their long-term sustainability, and ultimately gauging the impact of any potential attrition on the property. 

“If I have a big tenant with questionable credit that is paying above-market rents, I have a problem,” adds Walters. “If I have a big tenant with below-market rents, I have an opportunity. Those risks need to be dollar-weighted.”

#3 – Look Beyond Tenant Size

Although there are clear benefits to leasing up with national-credit tenants, there are other ways to maximize value. “When you are looking at a building, tenant size and liquidity are indeed big issues,” says Davis. “However, while it’s great to have large tenants such as big banks and insurance companies, we like to mix them with growth tenants such as technology and media companies, who may not have the same size but possess growth potential.” He also encourages investors and managers to “think through lease terms. Rollover risk is a question of timing. Diversifying the lengths of leases in a building and staggering rollover offers protection.”

#4 – Offset Risks With Credit Enhancements 

Maximizing a portfolio by diversifying across tenants of varying size and liquidity requires additional risk mitigation. “We look at tenancy, and it’s ideally balanced between larger and smaller credit players,” says Walters. “From there, you cover credit risks, where they exist. It’s best to avoid overexposure to one tenant or industry [and] secure letters of credit from tenants where you have exposure.”

Davis agrees about the importance of obtaining necessary credit enhancements as a best practice, adding: “With subsidiaries, affiliates, or portfolio companies, if the actual signatory is not the parent company or sponsor, make sure to obtain a letter of credit, guarantee, or deposit as a backstop.”

#5 – The Need for Regular Portfolio Reviews

Staffing constraints put institutional investors at a disadvantage when trying to analyze their holdings at the tenant level. However, regular reviews—either annually or biannually—are highly recommended. Bhardwaj recommends that investors lean on their investment consultants for help, as well as conducting internal reviews, to ensure a clear picture of portfolio risk. When the strength of tenants is in doubt, Bhardwaj recommends that investors “spend the money and hire a third-party credit analyst,” not least where single tenants account for 30 percent of a property’s income.