How to do Credit Checks on Tenants

Dreaming of reliable, trustworthy, and enduring tenants? For commercial real estate (CRE) property owners, ensuring timely payments is crucial to maintaining a steady cash flow. But how do you verify a potential tenant's financial reliability before signing a lease agreement? One effective method is conducting a comprehensive credit check.  

In this guide, we delve into the importance of credit checks for commercial tenants and outline the steps to execute them efficiently. Stay with us to uncover the essentials.

Understanding the Basics of Tenant Credit Checks

Why are Credit Checks Crucial in Commercial Leasing?

Tenant credit checks are an essential part of risk management for CRE property owners. A tenant’s payment history, overall financial health, and past financial issues can give you a full picture of a tenant’s creditworthiness.

These checks provide valuable insights into your tenant’s ability to meet their lease obligations.

In the long run, by minimizing vacancies, you will protect your investment and increase profitability.

How are Commercial Tenant Checks Different to Residential Tenant Checks?

Although credit checks are common for residential tenants, they come with their own unique set of challenges and considerations when conducting them in a commercial setting. This is largely because commercial leases are unique and have distinct financial dynamics.

• Commercial tenants are often business entities as opposed to individuals.
• Commercial leases often involve more complex lease structures.
• Specific financial evaluation criteria for commercial tenancies may include the tenant's liquidity, debt service coverage ratio, and profitability margins.
• Commercial tenants are susceptible to industry-specific risks and market fluctuations.
• Commercial leases also often require additional financial guarantees from tenants to reduce risks for property owners.
• Commercial leases are subject to different laws and regulations than residential leases, such as zoning regulations and niche compliance requirements.
• The screening itself may involve compliance with industry-specific laws and regulations that govern tenant credit checks.

Legal Considerations for Commercial Tenant Credit Checks

Navigating Federal and State Regulations

Navigating federal and state regulations is important when conducting credit checks on commercial tenants.

The Fair Credit Reporting Act (FCRA) is a federal law that governs how consumer credit information is collected, shared, and used.

For instance, CRE professionals must obtain tenants’ consent to access their credit reports.

Non-compliance of FCRA regulations and fair credit reporting procedures, or violating tenants’ privacy rights, can result in costly lawsuits, fines, and other penalties.  

State-specific laws, such as California's Investigative Consumer Reporting Agencies Act (ICRAA), can complicate credit checks.

Under ICRAA, landlords and property managers must provide tenants with more detailed notice than the FCRA stipulates before conducting a credit check.

This notice must outline tenants' rights, including the right to request a copy of their report and dispute inaccurate information. Tenants must also give written permission for such a credit check.

New York's Tenant Fair Chance Act (TFCA) focuses on residential properties. It sets out how real estate agents and landlords can weigh past convictions against applicants for housing.

It may impact commercial leasing transactions, especially if residential components such as mixed-use properties or live/workspaces are involved.

The TFCA also states that landlords must inform applicants that they intend to carry out a background check.

If a landlord rejects an applicant because of a conviction, they must give the tenant time to correct any inaccuracies in the report.  

Ensuring Compliance Throughout the Credit Check Process

The easiest way to ensure compliance in the tenant screening process is to adopt best practices for protecting tenant information and maintaining meticulous record-keeping.

Let’s look at a few best practices.

• Implement robust data handling procedures to safeguard tenant information throughout the credit check process. This includes encryption of electronic documents, secure storage of physical records, and restricted access to sensitive information only to authorized personnel.
• Obtain written consent from your tenants prior to accessing their credit reports and keep detailed records of consent forms on file for each of your tenants.  
• Clearly document your credit check purpose and scope, including the specific information you’re collecting, as well as the agencies involved.
• Establish confidentiality protocols so that you’re only sharing your tenant information with authorized personnel. Limit access to your records and provide training on confidentiality requirements to employees handling sensitive information.
• Develop retention policies that outline and adhere to legal requirements about the length of time you’ll retain your tenant information and how you’ll securely dispose of your outdated records.  

How to Do Credit Checks on Tenants: Step by Step

1. Obtain consent from the tenant to conduct a credit check. This is crucial for compliance with regulatory requirements. It also ensures transparency in the screening process.

2. Choose a reputable credit reporting agency specializing in commercial credit checks. Factors to consider when making your choice:

• Reliability
• Accuracy
• Industry reputation

3. Provide the necessary tenant information to the chosen credit reporting agency, including:

• Full legal names/business name
• Social Security numbers
• Consent forms

4. Review the credit report obtained from the agency. Pay close attention to payment history, outstanding debts, and any derogatory marks.

5. In addition to the credit report, assess any additional financial documents provided by the tenant, such as bank statements or income verification documents.

6. Look out for red flags indicating potential financial risks. Evaluate these red flags in the context of the tenant's overall financial situation and business plan.

7. Make an informed decision based on the information gathered in the process regarding the tenant's suitability for the lease. There are a few factors to keep in mind before finalizing the lease agreement, such as:

• Financial stability
• Creditworthiness
• Potential risk factors

Red Flags and Warning Signs in Tenant Credit Reports

Identifying red flags and warning signs in tenant credit reports is incredibly important to minimize risks.  

Minor issues may not be disqualifying, but major financial issues could mean a tenant is in danger of falling behind on lease payments.

It’s important to consider the context around red flags. Think about the tenant’s business plan, market environment, and financial stability.

Examining additional financial documents (such as bank statements or income verification) can also help you to gain a better understanding of their financial stability.  

When you compare red flags to other factors, you’ll be able to make more informed leasing decisions that carefully weigh risk management against growth opportunities.  

Common Red Flags to Watch Out For

• Patterns of late payments or default
• High debt-to-income ratios
• Significant negative entries such as bankruptcies or evictions
• Low credit scores
• Outstanding debts
• Discrepancies in payment history

Best Practices for Making Informed Leasing Decisions

Use Deposits or Guarantees to Balance Financial Risks with Growth Opportunities

Security deposits give landlords a financial buffer against potential damages or unpaid rent. They serve as collateral in case of a lease violation or tenant default.

Guarantees provide additional security by holding other people or entities responsible for meeting lease obligations if your primary tenant does not. As a result, landlords have an added layer of financial security and recourse.  

Create a Comprehensive Tenant Screening Process

A thorough tenant screening process includes various elements:

• Financial checks
• Previous landlord references
• Interviews with potential tenants
• Expert screening services

All these factors help shed light on many aspects of your tenant, including:

• Financial situation and past rental history
• Level of professionalism (including communication abilities)
• Fit for your property

Combining a thorough screening process with a professional screening service can reduce risks, ensure legal compliance, and help you make better leasing decisions.  

Adapting Screening Processes to Changing Market Conditions

As economic trends evolve, tenant screening processes must evolve, too. There are two main things you can do to stay the loop:

1. Stay Current with Economic Trends and their Impact on Creditworthiness

When the economy takes a turn for the worse, tenants may find themselves paying late more often, or defaulting on their leases. Companies may experience a decrease in revenue or even close their doors, impacting lease agreements.

Uncertainty in the market and lower consumer spending can also have an impact on tenant viability, particularly in industries that are prone to economic downturns.

This means landlords need to adjust their screening and risk management processes to reduce these risks for themselves and their tenants.  

2. Use Technology for Efficient Tenant Screening

In addition to traditional credit scores, advanced analytics, and artificial intelligence (AI) can help predict tenant success by looking at factors beyond the credit score itself.

These technologies can look at things like payment history and income stability, as well as industry trends and market conditions, to create predictive models of tenant behavior and financial performance.

AI algorithms continually learn from data patterns. This allows for more accurate assessments of tenant creditworthiness and the likelihood of lease fulfillment.

Online screening platforms offer benefits, such as:

• Convenience: Streamlined and efficient tenant evaluations and reduced administrative burden associated with traditional screening methods
• Speed: Rapid results through automated online platforms, enabling faster decision-making and reduced vacancy periods
• Accessibility: Often available 24/7, providing accessibility for both landlords and tenants to initiate and complete the screening process at their convenience

However, there are several considerations to keep in mind when using online screening platforms:

• Data Security: Ensure that online platforms adhere to stringent data security protocols and compliance standards to guard against data breaches or unauthorized access.
• Accuracy and Reliability: Verify the accuracy and reliability of the information provided and conduct due diligence to assess the credibility of screening services.
• Compliance: Ensure that online screening processes comply with relevant laws and regulations.

Final Thoughts on Commercial Tenant Credit Checks  

While it’s important to know how to do credit checks on tenants, it’s just a part of a comprehensive commercial tenant screening process. In essence, a thorough tenant screening process is a balancing act between financial risks and growth opportunities.

While credit checks can unlock essential information regarding a tenant’s financial reliability and their ability to meet rent obligations, property owners need to consider the broader context. Partnering with a knowledgeable CRE broker can offer additional support in navigating this process.  

At its core, the practice of conducting credit checks is instrumental in protecting your CRE investments. Yet it's important that they don’t become a barrier to exploring new business avenues and growth potentials. Establishing and maintaining appropriate tenant screening protocols can serve as a gateway to discovering and leveraging untapped market opportunities. It's time to take the plunge!

‍