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Assessing Covenant Strength

Assuming a commercial property is let already, the proposition an income-producing investment, the investor would be buying the building/property, not the tenant's business. Since the purchase price is geared to the passing and reversionary rent, it is normal to assess the tenant's ability to perform the tenant's covenants in the existing lease. Such covenants are not limited to rent, they include any and all other payments under the lease, whether defined as rent, for example insurance, service charge, or non-specific such as cost of compliance with repairing and decorating covenants, and statutory obligations. Where the property is vacant and to be let, whether a prospective tenant's covenant would stack up should be a matter for thorough investigation before agreeing heads of terms or executing the lease. The same applies to applications for licence to assign and underlet. The prospective assignee is a reflection of the existing tenant's requirements: whether those requirements also have to satisfy the landlord depends upon whether there is any criteria in the lease and/or the particular landlord. On underletting where the underlease is to be outside LTA54 the concern is that the under-tenant would know from the onset that it would have no legal right to remain in occupation on expiry of the contractual term of underlease.For due diligence, on the face of it, a most important factor is whether the existing tenant is or prospective tenant would be able to perform the tenant's covenants without reminder from the landlord. With a prospective tenant, ability to pay might be taken for granted with a renowned covenant, the tenant'�s information pack that accompanies offers is designed to reassure. A lesser covenant would expect enquiries seeking satisfaction by any existing landlord(s) and any other independent referees. A bank reference and reference(s) from proposed suppliers, and character references, might say something but are often of little or no use.Whether renowned or lesser, the test is not only whether the prospect is honourable to those on the prospect'�s side to begin with, but also to those that are not. Where the prospective tenant is a first-time business tenant (and new business), a guarantor and/or rent deposit (or both) could underwrite any doubts. The financial substance of the guarantor should be checked out. Subject to the sums involved, the more the resistance to the requested amount of deposit, how many months rent the deposit represents, the more risky the prospect. As for when the property is registered for VAT, for a prospective first-time tenant to question whether having to pay VAT is necessary should set off alarm bells in the landlord's mind. Both sides of the tenant'�s story is required. Unlike the tenant'�s bankers, its trade suppliers, any character referees, the landlord is not a supplier as such. That many tenants regard landlords as suppliers of property doesn'�t mean landlords should think being done a favour. Just because socialism wants to equalise the relationship between landlord and tenant doesn'�t mean landlords should give up hierarchy. In fact, landlord fear of the investment consequences is one reason for many tenants avoiding falling by the wayside. They might never admit it publicly, but many successful tenants are fed up with unfair competition fuelled by passive landlords being over-accommodating towards tenant covenant performance; such landlords are effectively subsidising the duds.With a new letting, as much information as possible concerning the prospective tenant's ability to pay/perform the tenant's covenants should be obtained, investigated and double-checked as a matter of course. The test is not merely whether the tenant could pay the rent and perform the tenant'�s covenants, etc assuming the tenant'�s business is successful, but what would happen if the tenant'�s business were unsuccessful. Few tenants are of independent means. Most tenants live off cash-flow, which means that the landlord'�s exposure to risk depends upon the tenant'�s ability to avoid cash-flow problems. In problematic circumstances involving a business tenancy, a landlord is not obliged to mitigate its loss. Nor it is obligatory, unless stated in the documentation, for a landlord to have to withdraw funds from any rent deposit. The landlord can insist the tenant makes its own arrangements for compliance. Requests to pay the rent monthly, rather than quarterly, really ought to be investigated before deciding. Such a request could be symptomatic of a tenant in difficulty, caused by not attracting the right sort of customer. Rather than concede, it might be better be rid of the existing tenant and relet to a better tenant.With an existing tenancy, where the rent is up-to-date and paid on time, two questions for pre-contract enquiries, doesn't mean the rent would continue to be paid on time, only what the seller knows before completion of the proposed sale. What is known about at the time judging by past track-record is probably the most the investor can hope for.Where the existing tenant is an assignee, in addition to appraising the assignee's own existing financial standing, the value of the privity covenant might influence the purchase price. Usually, well-advised assignors would take steps to limit their responsibility in the event of assignee default. Whether possible for the landlord to prevent the strength-value of any privity contract, whether pre or post AGA, being weakened depends upon the status of the assignor party. Normally, a landlord has no control over the financial state of affairs of an assignor. A corporate assignor such as a limited company could strip out all assets, and/or change its company name, (form a new company and change the new company name to the previous company'�s name) to protect trading brand name, or arrange for the company to be dissolved. Unless the landlord keeps tabs on the assignor'�s activities, the landlord would be none the wiser until the assignor is called upon to perform the tenant'�s covenants through default of the assignee whereupon the landlord could discover that what might have been thought a substantial cushion in the event of assignee default is in fact effectively worthless. Generally, I think it safe to assume that after a corporate entity of any note has assigned a lease that entity would rearrange its financial affairs to avoid any comeback.Where the assignor is a person or persons, it might be difficult, if not impossible, for the assignor person(s) to arrange their financial affairs to avoid future adverse consequences. Generally, such assignors would have to take a chance that the assignee would be honourable, and/or the assignor untraceable, and/or that the landlord wouldn't go after the assignor but forfeit the lease regardless.While on the face of it rent payment and performance of tenant covenants is an important factor, the key factor is the marketability of the investment in future. Basically, assuming the tenancy management matters are in order, the question to answer is whether the proposition will at least maintain its value and better still increase in value. Investment value is geared to passing and reversionary rent. The reversionary rent is the estimated (open) market rental value (EMRV) if a forthcoming rent review or lease expiry/renewal were today. EMRV for a rent review is only easy to estimate reliably when, assuming no other source available to the investor, more than outline evidence is presented. Investment agency and auctioneer practice of including brief details of recent transactions nearby as indicative should not be relied upon as sacrosanct: providing only the bare minimum details of a transaction can be misleading.On expiry of the existing lease, the reversionary rent itself might be more than the rent currently passing. But what an investor cannot assume, let alone be certain of, at least not without insider-knowledge, is that the existing tenant would want to renew at a higher rent and/or at least on the terms and conditions commensurate with the price paid for the investment, or the highest price the investment would fetch if offered for sale after the renewal lease were completed. Nowadays, it is just as likely that the tenant would not renew unless the tenant can agree the terms that particular tenant wants. Tenants whose covenants count for something in the investment are well-aware of the capital value of their covenant to the investor. Rational acknowledgement that tenant management is business and nothing personal is one thing. Quite another for investors to have to emotionally accept that the tenant doesn'�t care a jot about the wider consequences of the renewal terms for the investor.As for premises where the likelihood of reletting at anything like the rent the landlord might aspire to, it is not only whether that aspiration could be unrealistic, but that the sort of tenant previously in occupation of such premises would also be commensurate to the covenant quality of the outgoing tenant.A long time ago an experienced investor admonished me for suggesting that for purpose of investment a group company was effectively the same as the parent company. Ever since, I have been more critical of investment agency particulars and careful to look out for anomalies. With a corporate tenant, the legal tenant, for purpose of the lease, does not have to be the public face of the tenant'�s business. Often, the legal tenant is a dormant company. HMRC and Companies House have different rules concerning dormant companies. Finding out precisely what a dormant company can and cannot do is no easy task; I am not even sure that what I am about to say is correct. For example, although a dormant company can pay the rent without prejudicing dormant status, what a dormant company cannot do is pay anything beyond the requirements of the lease. In a matter I dealt with recently involving a well-known quoted plc whose group company was the legal tenant and dormant, the landlord agreed to pay the tenant'�s costs following a rent review, the costs incurred by the tenant'�s surveyor. I refused to recommend my landlord client to pay the tenant'�s surveyor'�s invoice, insisting instead on an invoice issued by the dormant company. The protest that payment of the costs direct to the surveyor amounted to the same thing as the tenant paying the surveyor then recovering the cost from the landlord was I considered a device to avoid the dormant company trading. In keeping with my desire to be honest and truthful, I reported the incident to HMRC.Generally, it is an idea for forward-thinking investors to take note of what is happening in other investment markets. Increasingly, concern is growing about the relationship between a corporate tenant'�s (1) turnover, pre-tax profit, shareholder funds and (2) that tenant'�s pension fund deficit. On the London Stock Market, a significant number of FTSE 100 companies have pension liabilities greater than their equity values. Deficit calculation is often worst scenario: the cost of transferring responsibility for the pension scheme to an insurance company. The deficit might be less of a problem where the company is profitable and making pension trustee acceptable contributions to reduce the deficit. However, where deficit can matter to the property investor is when the company is starved of cash, because its level of indebtedness is high, its turnover exclusive of VAT is static or falling, but its operating costs and overheads rising. In such cases, the company'�s way of reducing costs and maintaining margins could be taken out on the landlord through resistance to rent increases, payment delays, and trivial queries for tenant covenant performance compliance. Tenant covenant quality where the company'�s pension fund is in deficit should also affect the investment yield. Where pension deficit is an issue, the balancing act between appeasing shareholder desire for dividends and pension trustee desire for increased contributions means the money has to come from somewhere. Investors would do well to remember that tenants can be good at keeping up appearances.


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