Retail Credit Quality Will Strain as CMBS Issuance Surges
Sam Chandan May 30, 2013, 9:59 a.m.
Fueled by investors’ renewed appetite for risk and the relative stability of bond yields, CMBS issuance in 2013 is pacing far ahead of last year. By early May, volume had surpassed $30 billion, roughly three times the 2012 year-to-date tally. An uptick in the number of well-qualified borrowers is only part of the story. As it expands, the credit quality of the larger underlying pool shows signs of an increasingly flexible approach to underwriting. Too many investors are unfazed by the credit drift, largely content that anchoring to existing cash flow obviates risk along other dimensions. Fitted with blinders, those investors run the chance of being outflanked by new drivers of loss, including inadequate cushions against rising interest rates. As the cyclical attention to risk dissipates, a longer list of ratings agencies in the post-crisis era still brings fresh perspectives to the marketplace. It has also invited a new round of ratings shopping.
Barring a shock to the bond market or to the modest economic supports for property fundamentals, CMBS market participants see issuance rising to as much as $80 billion in 2013. That’s a far cry from the unsustainable market peak of 2007. It’s still a large enough leap from 2012 that it poses the question of how we’ll get there. Small retail properties are the stuffing in the CMBS turkey. That’s unlikely to change. With competition on the rise for lending opportunities across property types, the conduit cannot rely solely on expansion of market share in other sectors. There is the oft-cited wave of maturities, but we’ll have to dip into a deeper risk pool if unmodified refinancings are the answer.
Retail properties have already registered improvements in liquidity on account of better access to financing. The long and short of first quarter originations—including retail loans made by banks, life companies and through the conduits—shows some room to push the envelope but does not exhibit the underwriting conservatism a year ago:
• Underwritten cap rates on neighborhood and community shopping center loans averaged 7.0 percent in Q1 2013, down just 20 basis points from a year earlier. Retail’s perceived safe havens, including grocery-anchored centers, risk overcapitalizing current income. Valuations on regional and super regional malls showed bigger gains; mall cap rates declined 40 basis points over the year, from 6.8 percent in Q1 2012 to 6.4 percent in Q1 2013. Across all retail properties, the interquartile range spanned from 6.1 percent to 7.4 percent.
• Malls commanded lower cap rates but not lower debt yields. Across all retail properties, debt yields averaged 10.7 percent in Q1 2013. The interquartile range covered roughly 200 basis points, topping out at 11.5 percent.
• Against a loan-to-value ratio of 64.5 percent, the average interest rate on long-term fixed-rate financing was 4.4 percent in Q1 2013. Interest rates were substantially lower for malls than for neighborhood and community shopping centers; at comparable debt yields, debt service coverage was markedly higher at malls. Largely a function of their shorter lease terms, projected volatility in coverage was higher for shopping centers.
• Across value tiers, retail property valuations showed less variation than office or industrial assets. Average cap rates on retail properties valued under $5 million and above $25 million spanned a range of fewer than 100 basis points. The former accounted for 10 percent of assets but less than 2 percent of lending dollars. In comparison to retail assets, industrial property cap rates covered a range of more than 200 basis points.
• Urban storefronts accounted for a larger share of retail financing activity in core metros, where cap rates averaged 5.4 percent during Q1 2013. In the central submarkets of Boston, Chicago, Los Angeles, Manhattan, San Francisco and Washington, D.C., borrowers raised well over $10 dollars in debt for every dollar of operating income. Elsewhere, income leverage was lower and average cap rates consistently exceeded 7.0 percent.
• Some of the riskiest lending is on single-tenant triple net retail. Underwritten cap rates and debt yields on established fast food chains and bank branches often rival the most aggressive loans in the apartment sector. With a long-term lease and top-shelf tenant, the cash flow security might justify a loan that will boast a negative real interest rate before it matures. Not every bank branch with an upcoming lease roll will see its tenant renew. The uncertainties of a retail banking sector in flux and the United States’ overabundance of bank branches is poorly reflected in recent underwriting.
Housing’s tempered wealth effect or a positive inflexion in the job market could see consumer activity accelerate. At a juncture where rising interest rates will need an offset from fundamentals, that will have varied knock-on effects for brick-and-mortar retail space absorption. On the supply side, the development pipeline is subdued in most submarkets. Lenders ceding ground on underwriting standards because of competitive overlaps should be careful in baking these trends and expectations too deeply into loan structures. We might be bullish on the retail sector outlook, but the risk is in the sector’s not insubstantial tail. Giving the tail its due can be challenging when things are going well. After all, pressure to assume the best can be infectious.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at firstname.lastname@example.org.
Note on Sources: Chandan Economics’ national and metro debt trends are based on primary data collection of mortgage terms at origination, including loans made by banks, life companies, conduit lenders, and agency lenders in the case of multifamily properties.