Improving the Commercial Real Estate Appraisal Report: Tenant Analysis

In many cases, the tenant analysis in appraisal reports does not give sufficient attention to evaluating the creditworthiness of a tenant, and this is especially true with retail properties. A careful understanding of a property’s tenancy is critical for providing a creditable valuation conclusion. Cash flow analysis is what drives the value conclusion; therefore, establishing the basis for assessing the quantity, quality and durability of the income and its future performance potential is the pillar for a discounted cash flow analysis. For properties with multiple tenants, many appraisers tend not to give sufficient attention to the assumptions regarding tenant quality, credit loss and tenant retention. Even for many net-leased properties, appraisers often fail to carefully analyze publicly available information for that tenant.

When Situs RERC reviews appraisals (or completes our own appraisals), we expect to see an in-depth analysis of the tenancy. This requires that property managers, investment managers and even the landlords all provide their perspective on a particular tenant’s business, its financial condition, space utilization, growth and retention prospects. These sources all need to be engaged to develop as much primary intelligence about the tenancy as possible. Indeed, many of the participants in the investment process — and in particular, banks — require tenant financial statements and in-depth tenant credit information. The appraiser can develop a clearer risk profile of a tenant through carefully incorporating this information about the businesses’ prospects for growth or consolidation.

For multifamily properties, the demographics of the tenancy are critical to understanding annual turnover and credit exposure to critical employment centers. The tenant application process is a good way to verify that an apartment property’s tenants can afford the rents and absorb rent increases. Indeed, an affordability analysis of rents is also an important and easy way to examine the feasibility of the contract and market rent.

Higher-profile commercial tenants often have publicly issued debt, which have ratings, pricing and yields. Even when the company does not have publicly traded debt, a credit spread comp set can outline a range of credit spreads that could relate to the credit profile of the subject property’s tenancy and help select appropriate investment criteria. Considerations for liquidity and investment term also need to be factored when using this approach.

In summary, appraisers should dissect and thoroughly analyze the property’s tenancy. This is essential to drawing reasonable conclusions for critical assumptions such as tenant retention (frictional vacancy), credit loss and investment criteria. Both primary and secondary research tools should be deployed to thoroughly examine the tenancy. Producing credible results requires this critical information and perspective.

For more information, please contact James Molloy.