So what is this “credit enhancement” that I keep hearing about? It’s simply the latest buzzword for a real lease guarantee; i.e. one that will pay off. When one thinks about it, it’s a pretty descriptive term. In past bankruptcies, because lease obligations were unsecured, landlords frequently didn’t get anything, regardless of what the lease said about the tenant’s obligations on default. After other creditors had been paid off, there frequently was nothing left!
After having been badly burned in the recent real estate recession, landlords are now saying: “Never again, I’m going to require that the tenant ‘enhance his credit’ so that I’m sure of having my losses covered before other creditors”. To do this they are asking for, and getting, Irrevocable Letters of Credit that they can present on default to get their money without any question.
And as you might imagine, the problem is particularly acute with young, or startup companies that really have no credit history. In a worst case scenario, space with highly specialized tenant improvements can be vacant for a year or more. And the replacement tenant may not be able to take advantage of those specialized improvements that are then a complete loss. With high tech NNN rents at $15/RSF/yr and specialized TI s at $20-50/RSF, it is easy to see why landlords’ in some cases are asking for Letters of Credit equal to three years rent!
But is this really a “fair” amount? Certainly, over the lease term the amount should decline as the specialized TI portion is amortized as part of the rent. Similarly, the broker commission portion should also decline as it is amortized.
This leaves us with “coverage” for the period that the space may be vacant. Nobody really knows how long it will take to release a space and redo the TI s. Even if a new tenant is ready to take the space, it still takes time to negotiate the lease terms, space plan, prepare working drawings, get approval from the city building department, and buildout the space. For a substantial rebuild this could easily take six-seven months. Even if the space only requires minor changes, it could still take three months. And remember there is not only no income during vacancy, but also continuing operating expenses. At a NNN rent of $15/RSF/yr plus operating costs of $6/RSF/yr, this is $1.75/RSF/month. For a three-month vacancy this is equivalent to four months NNN rent, and for a seven-month vacancy, 10 months NNN rent. If we add a couple of months to find a tenant, this is a “gap” of 6 to 12 months of NNN rent. So for starters nine months NNN rent plus the cost of the specialized TI s and brokerage is not unreasonable.
But this initial rental period should also decline since built into the NNN rent is a “risk premium” to cover such items. So as the years go by and this “risk premium” is earned through NNN rent payments, this portion of the guarantee amount should decline directly with time.
The following example for a five-year lease on 10,000 RSF will help illustrate. We have assumed at NNN rent of $15/RSF/yr escalating at 2.5%/year, with $20/RSF of specialized TI s and 5% brokerage.
In this case, about a third of the total is in lost NNN rent, and the remaining two-thirds for amortization. The Letter of Credit for the first year would be for $350,000, declining to $85,000 in the last year. Letters of credit require some form of security (they are not insurance policies, at least not for the borrower), cost 1-1.5%/year, and are renewed each year for the declining amount.
This example shows how important it is to keep the specialized TI s to a minimum. If we had assumed only $5/RSF, the initial LoC would have been only $200,000. Further the Landlord charges a higher interest rate to amortize those TI s (12% in this typical example). You may be able to borrow at Prime (8.5% today). So consider financing your specialized TI s yourself. You save both interest and reduce the cost of the LoC.
|ILLUSTRATION OF CREDIT ENHANCEMENT OVER TIME|
|10,000 RSF 5 YearTerm|
|$/RSF/yr NNN 2.5%/yr increase||$ 15.00||$ 15.38||$ 15.76||$ 16.15||$ 16.56|
|Specialized TI s $/RSF||$ 20.00|
|Brokerage @ 5% = $/RSF||$ 3.94|
|Guarantee Amount||At Start of Year|
|NNN Rent Portion, Months||9||7.2||5.4||3.6||1.8|
|Unamortized TI s/brokerage $/RSF @ 12%||$ 23.94||$ 20.23||$ 16.04||$ 11.32||$ 5.99|
|Letter of Credit|
|Rent Portion||$112,500||$ 92,250||$ 70,917||$ 48,460||$ 24,836|
|Amortization||$239,422||$ 202,312||$ 160,413||$ 113,247||$ 59,856|
|Total||$351,922||$ 294,562||$ 231,330||$ 161,707||$ 84,691|
|Rounded||$350,000||$ 295,000||$ 230,000||$ 162,000||$ 85,000|