MSCI says investors should widen tenant-default risk analysis as market worsens

Tenant-default risk analysis in real estate portfolios is often focused on the largest tenants by rental income due to resource or data constraints, but the underlying data suggests this practice may be inadequate, according to property research and data firm MSCI.

Inflation is putting severe pressure on the cost bases of companies, while also dampening consumer demand for products. Both of these factors impact the ability of tenants to afford rents, which ultimately drive real estate’s income returns. Rising inflation is also leading to increasing interest rates, further reducing the free cash flow from the portfolios of levered real estate investors. Against this backdrop, understanding tenant-default risk is more important than ever.

The collection of tenancy data across a whole portfolio and consistent analysis of tenant-default risk are both time-consuming and difficult. In MSCI’s experience talking to real estate managers and investors, it emerged that many do not go beyond analysis of only their largest tenants.

The analysis of only the top 10 tenants by rental income may be inadequate for many real estate investment funds, because this rental income often represents less than half of portfolio income, and the sector allocation and tenant-default risk distribution can often be substantially different from the rest of the fund. It is easy to miss significant risks with such a narrow focus, MSCI said.

Top-10 analysis is only part of the picture
Fund size is an important factor in understanding exposure to tenant-default risk. Larger funds tend to have a greater number of assets and more tenants. With a greater number of tenants, the concentration of total fund income within the top 10 drops as the fund’s income stream becomes more diversified.

Not only does a focus on the tenant risk of the top 10 risk missing a large proportion of income from the analysis, but the spread of income across property types can be substantially different between the top segment and remainder of tenants. This could be particularly relevant in today’s market conditions where occupier strength, as well as the likelihood and potential speed of reletting, may be expected to vary across property types.

MSCI believes that focusing on tenants contributing the largest rental income could lead to partial and biased analysis, potentially missing significant risk exposures in the portfolio. 'As macroeconomic conditions worsen and tenants come under more stress, making sure one has a full picture of tenant-default risk may become increasingly important for investors and managers of real estate portfolios,’ it said.

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