General Vacancy and Credit Loss (Credit Tenant)

[Anonymous]

Spencer,

When modeling the “General Vacancy and Credit Loss”, does one still assign a small percentage even if the tenant is a credit rated and/ or with the corporate guarantee during the lease period?

Let’s say the tenant is a Federal government agency, then the default risk is low. In practice, does one model this vacancy risk based on the credit rating per Moody’s or S&P?

Thanks,

Kyle Chuang

[Spencer Burton]

Kyle,

This is a great question. The short answer is, it depends on the credit risk of the tenant. You underwrite a B-rated tenant quite differently than you underwrite a AAA-rated tenant.

Of course in practice, every firms handles this credit risk issue a bit differently.

Some will just simply apply a ‘General Vacancy and Credit Loss’ factor to the tenant each year, depending on its credit risk.

Others will apply a rent payment limit, where the underwriter will say that a tenant will likely only pay rent a certain number of years depending on its rating (e.g. BB rating = max 5 years, AAA = max 30 years). At which point the tenant will vacate, irrespective of the actual lease term.

I’ve also seen some hybrid of the above, where the underwriter will initially assume no General Vacancy or Credit Loss but as the lease progresses, begin to add some credit loss factor each year.

And finally, some will just account for the credit loss in the reversion pro forma. So they won’t include any General Vacancy or Credit Loss throughout the hold period, but will include something in the reversion pro forma to account for a likely termination or lease default beyond the hold.

In the end, it’s dependent on the tenant’s credit, the length of the lease, and how sensitive the real estate professional wants to be to credit risk.

Thanks again!

Spencer

[Author]

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