Accounting for tenant default dynamics in logistics real estate

As corporate defaults are on the rise across Europe, logistics investors face higher probabilities of tenants not being able to meet their contractual lease obligations. Logistics assets have already experienced a level of repricing and focus is now shifting to the ability for continued strong and stable cash flow generation.

With this backdrop asset owners might need to evaluate their tenant base in more detail to anticipate potential issues but also to identify less obvious tail risks. Evaluating geography/market specific, sector specific and firm specific credit profile and credit quality migration characteristics are of course crucial, however more sophisticated tools can improve large scale analysis and provide more detailed and more accurate view of tenant risks.

Evaluating credit curve (credit rating and/or tenant probability of default), term structure (expected default probabilities through time, e.g. 10yr probability compared to 5yr, 3yr or 1yr) and conditional default correlations (conditional on some economic event or default of one tenant (A) based on default of another (B)) can provide deep insight into cash flow risk, tail-risks and quality of tenant base across assets and across time, such as expected investment period.

The below example illustrates one such dimension in a simple 2-tenant exposure where both tenants have a 5% probability of default in the next 5 years. The two panels compare the impact of default correlation when tenants are uncorrelated, e.g. operate in largely uncorrelated industries/sectors, and in more similar industries/sectors with correlation of 0.5. As the figure shows, there is a higher marginal probability that at least one tenant defaults when correlation is 0 but very low tail-risk (for the purpose of this note defined as both tenants default at the same time), which is only ca 0.3%. However, while this marginal probability falls for each tenant when correlation rises, tail-risks increase significantly to ca 1.4%.

Of course, these interrelated dynamics expand as analysis is done taking into account large number of tenants of varying quality as a staring point, operating across different industries and through time, e.g. 10-year period.

If you would like to evaluate the cash flow profile and stability across your logistics portfolio and tenant base, please contact info@kaniaadvisors.com

Impact of tenant default correlation on lease tail-risks

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