Beyond location: The rising weight of tenant and lease quality
The adage “location, location, location” has long rung true in commercial property. Investors once favoured prime CBD addresses and A-grade buildings in the hopes of strong capital growth, but the traditional parameters of a “quality” investment have shifted.
Tenant covenant and lease quality are now increasingly central metrics for underwriting a commercial property, helping investors better understand an asset’s risk profile and income durability. With higher interest rates and more expensive debt, investors have less margin for error and are placing greater weight on secure, contracted cash flow.
Rich Harvey, buyers’ agent and chief executive of Propertybuyer, says the change has been pronounced over the past few years.
“It’s kind of moved away from being speculative about capital growth and there’s much more of an intense focus on stability of yields,” he says. “The real value of a commercial asset lies in its ability and its obligation to pay the rent.”
The shift is evident from an agency perspective, too: “Longer-term contracted occupancy is very important, and then that covenant,” says James Mitchell, national director of capital markets at Colliers. “Exposure to tenants becoming available in a shorter period of time is something buyers are very focused on.”
The lease can also act as a hedge against inflation. Escalation clauses, such as CPI-linked rent reviews, help income keep pace with rising prices, while triple-net leases reduce exposure to rising operating costs by requiring tenants to take on a greater share of expenses.
“There’s definitely much stronger emphasis on covenant quality, the WALE and the rent increase mechanism,” Harvey says. “A well-capitalised tenant with a long lease and really clear escalation clauses gives investors a good long runway, particularly when you’ve got the threat of higher interest rates.”
In practice, the shift is playing out in transaction pricing and buyer behaviour. The premium attached to longer WALEs may make buyers willing to accept lower yields. ‘Blue-chip’ tenants such as national corporates and government agencies are seen as lower risk and more attractive than smaller operators, causing yields to tighten.
As Mitchell notes, covenant strength can be a powerful marketing lever during campaigns. “If you can utilise that covenant as a marketing piece to the asset, then it’s only going to attract a larger buyer pool,” he says.
All of this raises the broader question about where lease quality now sits in the investment hierarchy, and whether it can ever outweigh the asset itself.
In Harvey’s view, there are certain circumstances where it does. He explains that even secondary assets with blue-chip tenants and extended, well-structured leases are generating robust interest.
“A secondary office that’s being leased long-term to a national or a government-backed tenant can often trade more competitively than a short-term WALE industrial asset,” he says.
Mitchell agrees that a lease profile can support buyer interest in a secondary asset, particularly if it has strong underlying land fundamentals.
For institutional investors, tenant and lease quality are essential pillars of the underwriting process.
According to Centuria’s chief investment officer, Andrew Essey, tenant quality mostly comes down to “the probability of the tenant paying their rent and performing their obligations under the lease,” along with the expectation of “maintaining their position within that building for an extended period of time.”
Centuria’s latest results show its industrial portfolio carries a WALE of more than seven years, while around 75 per cent of office income is underpinned by government, multinational and listed tenants.
However, Essey emphasises that lease terms alone are not enough. “We don’t invest in an asset purely because of the tenant’s lease term,” he says. “There should be a keen focus on the fundamentals of that asset, because at any point in time, there is risk.”
Obsolescence risk, for instance, means a building may become functionally or environmentally outdated over time, reducing its future competitiveness.
Capital expenditure obligations, such as major structural works, plant replacement, and ESG upgrades, can also act as a deterrent, reducing the net certainty of income.
Essey notes that future capital expenditure requirements are always priced into acquisitions: “Cash flow can be valued exactly for what it is, as it is contracted by that tenant.”
Renewal probability – the likelihood that a tenant chooses to extend their lease at expiry – is another key variable in long-term modelling.
Property fundamentals also remain integral, with Essey adding that some sectors are inherently more defensive than others. Logistics, essential retail and healthcare, for instance, consistently attract investor demand given the non-discretionary nature of their tenant bases.
Ultimately, while tenant and lease quality are increasingly influential in pricing and risk assessment, they sit alongside many other considerations. Income durability matters, but so does what underpins it.
