Credit analysis is useful when considering the financial strength of tenants and other operating partners. When thoroughly underwriting an retail, office, or industrial property, an analyst may look at these measures to understand the caliber and quality of existing tenants, and therefore, what the future strategy and predicted rental income at the property may be.
The five C’s of credit analysis:
Capacity. This measures a company’s capacity to make debt service payments. In other words, can the tenant afford the rent every month? To find out, take a look at the company’s historical and projected cash flows. In their cash flow statement, look at the Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). This figure determines how much money is available to pay their rent. We use the EBITDA figure because it does not subtract depreciation and amortization – as it should be looked at – because depreciation and amortization are non-cash expenses.
Once the EBITDA figure is identified, credit analysts typically divide that number by any proposed debt service obligations. This calculation is called the Debt Service Coverage Ratio (DSCR). Typically, banks consider a 1.2x DSCR as a good benchmark. This means that the tenant can afford to pay their mortgage payment 1.2 times with their monthly income after expenses.
Collateral. Collateral serves as a back-up should the tenant be unable to pay their rent. A dollar value needs to be placed on the tenant’s collateral, but thankfully this is usually done by third parties. Collateral can be anything from inventory, equipment, other real estate, and accounts receiveable.
Capital. When analyzing a tenant, one should make sure that the tenant stands to lose something if the business fails. Chances of failing are much less in instances where the company has a lot of money on the line; they are incentivized to do everything in their power to keep the business alive and well. How do you measure the capital that a company has invested? Look at its debt-to-equity ratio, and expect a number less than 3x.
Conditions. This simply means that the landlord should be aware of the economics of the industry that the tenant is. How do macroeconomic conditions affect their business? Are there specific trends that are positive or concerning?
Character. A tenant’s character may be judged by the landlord. For example, a landlord may not be interested in having Hobby Lobby as a tenant given their involvement with controversial religious and/or contraceptive practices for their employees. Understanding a tenant’s character and public reputation is important in predicting whether or not they will have a PR disaster that may take them out of business and affect their ability to pay rent.
While other metrics may be used, these are the general items looked at by analysts who want to understand the quality of commercial tenants in a potential acquisition.