Part 1 of 3: How to identify a good tenant
The main goal of owning or managing any property is protecting and growing the asset’s value. Whilst this may seem fairly obvious, there is unfortunately no straightforward path to easily and consistently achieving this goal. One principal component of value in a property is the Rental Income generated. The fundamental source of Rental Income is the tenant.
We can therefore assume the following Property Value Protection Formula:
Securing a good tenant
+ Successfully managing the tenant
+ Retaining or replacing tenants
= protecting or adding to the value of property.
This advice applies universally to any property, big or small, residential, commercial or industrial.
In theory, this seems simple right?
In practice, there are numerous factors to consider when evaluating new tenants, managing them and, if necessary, cutting ties and restarting the entire process. This article addresses the first stage of this Property Value Protection Formula: how to identify a good tenant. Future articles in this series will tackle the balance of considerations in the all-important quest to protect and augment your property’s value.
Defining value as it pertains to the tenant
There are numerous factors to analyse when valuing a property. That said, almost all considerations for the calculation of a property asset’s value lie in the Rental Income generated in such property. The Rental Income is the total of the rentals payable by tenants placed at the property. The cumulative total of all rentals expected to be paid by the tenants in a property is also known as the Rent Roll. The Rent Roll is one of the cornerstones for valuing a property.
The value of the property is used, amongst other things, in sale price negotiations or applications for financing with lending institutions.
The (perfect) tenant
What is the connection between tenants and the Rental Income? Obviously, the tenants pay rental, which is the measure of the Rental Income generated by the property. Again, it’s not that easy. Good tenants pay rentals. They contribute to an attractive Rental Income total. They provide value. Bad tenants don’t pay rentals. They affect the Rental Income total. They reduce value.
Trying to predict whether a tenant will be good or bad at the time of negotiating a lease is like trying to predict a game of chess before the game has even begun. We don’t know, until we know, that the tenant will not pay rent timeously or at all. This forms part of the whole uncertainty of managing a property.
The credentials of a tenant can appear so strong on paper that the landlord considers them a “sure bet”. Based on this, this tenant receives preferential terms in the negotiations with the landlord who is eager to secure them for their property in order to increase their Rental Income. Unfortunately, I’ve seen many such “sure bets” fail to pay rental and even go into business rescue overnight, causing sleepless nights for everyone with a vested interest in the associated property.
It’s impossible to provide you with a blueprint for the “perfect” tenant. But based on my years of experience managing, litigating and negotiating with tenants, I can provide some insight on the best processes for you to implement to protect your property asset.
Vetting – planning for success
Benjamin Franklin is credited with the quote “Failing to plan is planning to fail”. This is so applicable for the placement of new tenants. Vetting may just be the most important stage of protecting the property’s value. I’ve been fortunate to be involved with several tenants from the lease negotiation stage to the ten-year milestone of occupying the same property. Observing this positive tenant journey has affirmed the positive power of correct and thorough vetting.
Longevity with a good tenant naturally leads to a consistent, positive effect on a property’s Rental Income. Unfortunately, I’ve also seen the contra of this. Poor vetting processes often result in leases not surviving beyond a couple of years and a negative affect on the property’s Rental Income.
Using vetting best practices at the time of interviewing, meeting and negotiating with a potential tenant can be the very step that underpins a long-lasting, mutually-beneficial tenant-landlord relationship.
Three of my best practices include:
- An in-depth background check on the potential tenant
- This includes searches on its directors
- It also includes understanding the nature of the tenant’s business and a macro understanding of the industry in which the tenant conducts business
- It is an overall view on the tenant’s business and its “jockeys”
2. Reference letters
- Preferably from an average of three suppliers
- Most importantly, obtaining a reference letter from previous landlord/s or current landlord/s at any other properties rented by them
This allows a landlord to ascertain whether the tenant is a good, timeous, payer of accounts. It also helps to understand whether they default on their obligations to their providers. Although debtors do not treat all creditors equally, this is a good snapshot regarding the tenant’s intention (or ability) to pay rental and associated charges timeously or at all.
3. A financial means analysis test
- This test is based on the tenant’s bank statements and/or management accounts or audited financials. For example, if the rental to be paid by the potential tenant is more than 30% of its revenue, it may be a good indication that they will not be able to afford the rental.
- Although not requiring the services of a Chartered Accountant, the person tasked with attending to this must understand operating expenses of a business as read against its revenue.
- As a bonus tip, on the assumption that there are deeds of suretyship being signed as a condition of the lease agreement, such sureties’ financial position should also be carefully considered. It’s no good having deeds of suretyship signed by the proverbial men of straw. Having a strong surety as co-principal debtor with the tenant is a powerful tool in securing rental payments and protecting the asset’s value.
Predicting the unpredictable
As dealt with above, there is no foolproof way of predicting a tenant’s conduct.
The above is a recommendation on how to reduce the landlord’s uncertainty and risk. It cannot accurately predict the future conduct of the tenant, but it will make a landlord alert to red flags. This is much better than blindly concluding a wonderfully exciting deal with a tenant, only to be disappointed shortly thereafter.
If there are warning signs, heed them. This does not mean that you need to avoid every potential tenant. It means that you need to be realistic about the probabilities of a potential future problem. Insist on a larger deposit or bank guarantee, more sureties, stricter lease terms.
This will ultimately be a great assistance in protecting the property value.
This article first appeared in Asset Magazine’s May 2021 edition