Commercial landlord-tenant loans: yes or no?

Commercial tenant loans aren’t often employed by landlords and property management companies. Here we break down the top 5 responses that are given as reasons for not providing tenant loans during lease negotiations, and show ways that commercial landlords benefit from providing tenant financing options.

Would you give a tenant financing?

Ask commercial landlords if they would consider giving a tenant a loan to pay for improvements to the leased premises, and there’s one standard response:

“We don’t do loans”.

If you press them further on why they wouldn’t consider financing a tenant loan when negotiating a new lease agreement and additional reasons come up. Let’s examine the logic behind the most common justifications that are presented.

Reason #1: We’re not a bank

This reason is brilliant! Banks take money from clients, pay those clients some interest, and lend it out to other clients for higher interest rates. In this situation landlords take money as rent, and give portions of that money away on each lease for free as incentives or allowances. That is definitely not bank-like behaviour.

Seeing that banks make money on everything they offer to clients, it’s not a proud business moment when you give this reason for not doing tenant loans. To clarify, why would you rather give money away than loan it out at interest? While it may be true that your real estate company isn’t a bank, there is a most compelling case for making loans instead of giving away incentives or allowances.

If cash flow is a concern, consider borrowing against the equity in the building. It is much more likely that a bank will lend the building owner money to do improvements to the property than it will give to a tenant who needs business financing to scale up to a new facility. Mortgage interest rates secured against real property are undoubtedly lower than unsecured rates available to a tenant, so the interest rate spread will work to the landlord’s advantage. In fact, the landlord could surely borrow at a lower rate and lend to the tenant for a 4-6% interest rate spread.

It is easier for a landlord to secure financing, and at a lower rate, than it is for a tenant to obtain unsecured credit. The one-source deal for the property and funding is markedly in the landlord’s favour if the alternative is sending a tenant to their bank for a loan.

Reason #2: We don’t want the risk

Risk of what, exactly?

Without a doubt loans have a risk factor for defaults. Although this may be true, giving money away is always a 100% loss without exception. It’s a complete write-off every single time. There is no possibility of recovery, full stop.

Alternatively, giving away money absolutely removes the ongoing risk of default, but it is very doubtful that the incentive process was designed with this purpose in mind.

The low risk of default for a tenant loan in contrast to the complete loss for an incentive or allowance clearly demonstrates that tenant loans are far less risky than any other method of getting money to a tenant.

It is evident that the way to remove risk is to properly secure the loan through the lease agreement, and not by explicitly accepting a complete loss from the outset.

Evaluating tenant risk

Every tenant gets evaluated on their creditworthiness when they send in a lease proposal. The financial score factors into the terms and conditions of the lease as well as the amount of incentives that could be given. Tenant’s that have a strong financial showing receive more favourable lease terms, lower rates, and correspondingly larger incentives. There is no difference in the type of financial analysis that is performed, regardless of the means by which credit or monetary rewards are extended.

Furthermore, tenant loans are secured by the lease agreement. In a properly written contract, a tenant cannot walk away from the loan without also losing the premises. This provides additional security to the landlord.

Reason #3: Tenants want free things, not loans

Is there resistance to loans from the tenant side? Obviously it doesn’t make sense to pursue the loan option if there aren’t tenants willing to take that route. But is this really the case?

Tenants want the premises optimized for their foreseeable business needs. That is the overall objective, regardless of how that is accomplished. Notwithstanding the fact any tenant would take free incentives over paying for them, it doesn’t preclude using other means to achieve their objectives.

What drives the requests for incentives and allowances?

The need for finances beyond what a tenant is able to carry at the time of the move drives the requests for incentives and allowances.

Firstly, moving disrupts a tenant’s income stream. During the time before the move staff are involved in evaluating the amount of space they need and the type of facilities that could improve work processes. During the move staff are disrupted from normal routines, and uncertainty slows whatever production is still able to go on. Moreover, the staff still working are doing so without the full strength of the workforce and leadership.

Secondly, equipment is often disconnected and reinstalled in the new premises. This additionally reduces output at a time when the old facility were already inadequate for production requirements.

Only charities and non-profits work on the business model of getting things for free. Every other for-profit business operates with the assumption they will have to pay for the things they want. What is needed for most tenants isn’t so much getting things for free as the ability to meet financial obligations during a time of reduced cash flow. For this reason, deferring payment for large expenses during this period of unforeseen costs and low productivity is very attractive. Providing financing for a tenant is an acceptable method of easing the transition to the landlord’s building.

Reason #4: We aren’t set up for making loans

Let’s break this down into two parts: internally working out how much to loan and what to finance, and dealing with the loan itself. The business systems portion of how to deal with the loan will be dealt with in reason #5.

What to finance?

This isn’t really that difficult. As a landlord you can start with whatever improvements that you might otherwise consider giving as incentives or allowances. So far as loans will give you a far greater chance of getting your money back, you could consider other work the tenant would want, but that you would consider too costly to capitalize otherwise.

For example, perhaps the building really could merit the installation of two additional loading docks.  The tenant may not have the cash to do the work now, but could really benefit from the increased productivity the docks could provide. The landlord may not be certain that the additional doors would generate high enough rents in the future to cover the capital cost now if given as a free incentive. A tenant loan would enable both parties to achieve their objectives with the result that it’s a win-win situation now.

Here is where another real benefit shows up: the possibility of a tenant loan has created a situation where the landlord’s building has actually increased in desirability!

Offering a tenant loan creates leasing possibilities that wouldn’t exist otherwise in the world of free incentives and allowances.

How much to finance?

If a property management company is prepared to offer a tenant a loan, how much should it offer to finance? There is a risk limit that was already determined when the tenant’s offer to lease was reviewed. The financial standing of the tenant and the proposed terms of the lease deal determines the amount of money normally allocated for lease allowances in cash or landlord’s work. Given that incentives would otherwise be given out with no expectation of a return, this amount is easily justified in the within existing business decision process.

What about additional work that might otherwise be a capital expense? The landlord-tenant loan is unique in that the landlord has an amazing amount of extra control that a bank just doesn’t have.

For one thing, the landlord has control over exactly what will be done. It has the right to examine the scope of work proposed, to approve how it will be done, and what materials will be used. The landlord can choose to finance work that is more generally suitable for the building and its functionality. It can opt for improvements that are likely to generate higher rental rates with subsequent leases.

As discussed in this article (https://cressblue.com/how-are-leasehold-improvements-accounted-for/), the landlord owns all the improvements made to the building. The loan is fully secured by the asset’s value. The risk of loss is mitigated by the fact that the landlord owns the leaseholds they financed. Regardless of whether the tenant defaults, the building still has the improvements.

Reason #5: Our business systems don’t support loans

Now that is a problem!

Most business decisions follow the path of least resistance to an acceptable solution. It generally is not the best solution, as perfection takes too much time to work out and implement. Any time a business process adds too many steps to a workflow, the best solution will be abandoned for the most practical solution by those required to implement it.

As we have seen, the financial evaluation for a tenant loan is the same process that is used to evaluate any tenant’s creditworthiness. The same types of improvements are available for consideration, but as was shown, the value of them could be increased due to the financing improvements rather than writing them off or capitalizing them. Clearly the case for landlord-tenant loans has been made. Balanced against that is the considerable resistance of property management business systems that don’t support the ability to account for tenant loans.

Ideally the system would show all aspects of the lease costs in one place:

• the total cost of improvements,
• the landlord contributions via incentives or allowances,
• the tenant’s contributions,
• the tenant’s down payment on any excess over approved expenditures

Following those records, the business software should have the ability to:

• generate a loan amortization table for use as a lease schedule,
• account for loan payments on the lease invoices,
• record any extra or lump sum payments and adjust payment schedules,
• keep track of the loan through any of the tenant, property, lease, and financial records simultaneously, and
• adjust automatically to the lease term dates in case of delays in the lease commencement.

Does such an ideal business solution exist? It exists in CRESSblue. Register for your discovery demo here.

Making the case for landlord tenant loans

Indeed, making loans available really helps smaller companies with limited cash get into a lease agreement. A loan creates possibilities that wouldn’t otherwise be considered for both the landlord and the tenant.

Additionally, it can be an easy revenue source for landlords. The legal cost is combined into the existing lease agreement setup. It’s an easy source of extra income derived from a property.

A tenant loan offer can significantly lower the amount of incentives a landlord would otherwise give away. Tenants ask for landlord incentives because they don't have the cash flow or ability to finance the work themselves. Landlord-tenant loans can work out very well for both the landlord and the tenant.

It doesn’t create any extra work in evaluating the loan risk or scope of work. It’s all within the original capabilities and expertise of the persons already making those decisions.

As a property management company, you want your business software systems to support the best business practices. If your systems make the ideal outcomes the easiest outcomes, you will get better results as the default workflow. Limited software systems not only waste efficiency; they also waste opportunities. In contrast, ideal systems create opportunities to allow competitive advantages others cannot match.

Effective leadership is about seeing opportunities and enabling others to seize them. Add landlord-tenant loans to your toolbox and get the business systems in place to implement your new best practices. Make the path of least resistance the optimum outcome.

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