Do sophisticated Lenders (or do I mean Lenders who care?) recalculate shopping center rent revenues on a pro forma basis before making a loan decision? I have no idea. That leaves me free to speculate.
Ignorance frees us to look at things afresh because we can’t follow the unconscious path of plugging everything into an previously used formula. With that as the foundation, I’m thinking that a Lender should be looking at two kinds of rental income – the one that the Leases provide for (the stated rent) and the one that the market dictates. I’m sure that the appraisal value of the property cares about the market rental value, but collateral value is only one of the important credit factors. The other is: “ability to pay the Loan.” For commercial properties, that is less a function of personal credit than it is of cash flow from the property.
So, one would look at the existing Leases and take into consideration those with creditworthy tenants (not just “credit” tenants). That is the source of the money that will be used to pay the loan. But, the stated fixed rent can’t possibly be the figure used. After all, some of that money is needed to pay property expenses. So, does it really make a difference if the base rents at a property are charged with pass-through expenses on an escalation basis above a starting point (where the base rent figure would be higher) than if they are stated on the basis that Tenants pay a share of the pass-through expenses starting at dollar one (where the base rent figure would be lower)? I don’t think so, and I suspect Lenders know the difference.
With that as the premise and that as an example of how two properties with significantly different aggregate base rental figures can have the same net cash flow and the same ability to pay a mortgage loan, here’s what’s been ruminating in my mind. Doesn’t the same question or issue come up when the rent is pumped up by giving a large rent waiver up front – think, six months free rent – and then the base rent figure is thought to be “market”? I assume that Landlords expect that if they take a loan, the Lender will use the stated rent in the Lease as the amount available to pay the mortgage. Setting everything else aside, assume we’re talking about a loan taken after the free rent period has expired.
Now, from an accounting point of view, this kind of rent structuring really doesn’t change how a Tenant is required to “book” its rent expense. Trust me on that, Tenants can’t book rent on a “cash paid out this month basis,” they need to calculate an effective monthly rental over the term of their Leases. Yes, it affects their cash flow by saving cash up front and trickling it out later, but that really isn’t needed by Tenants who can command big concessions.
Here, however is the effect. Hypothesize a two year lease with a six month free rent period. If the stated rent is $10 per square foot collected over 18 months, the effective rent is only $7.50 per square foot over the 24 months. That means that the market rent was only $7.50 per square foot when the Lease was signed. A replacement Tenant will pay $7.50. A Tenant signing up the next day will pay $7.50. If a Tenant wanted a fit-up allowance, the Landlord could pay $5.00 per square foot to the Tenant and charge $10.00 per square foot rent for the entire 24 months and come out whole.
From a Lender’s point of view, however, when the tenancy turns over or the Lease is extended, the rent is still only going to be “market” rent. So, what figure does or should a Lender use when calculating a shopping center owner’s ability to pay back? If Lenders do this kind of analysis (and, I’m really asking if they do a far more sophisticated analysis than that of my simple examples), are property owners fooling themselves when they think they are juicing up their rent rolls to be able to borrow more money or have an easier time finding a willing lender?
Chew on that one. What does anyone think?