“Writing a check separates a commitment from a conversation.” – Warren Buffett
Commercial mortgage-backed securities spreads have narrowed over the last few months, so cautious optimism abounds. When talking about retail assets though, that optimism is muted. While it has been well documented that the CMBS market has seen a dramatic drop in volume ($19 billion in the first quarter of 2016 versus $27 billion in the first quarter of 2015), the victims of this plummet haven’t been exposed. Most people probably just assume that local and regional banks filled the void or borrowers simply limped along with their existing loans without being able to take advantage of today’s low-interest-rate environment. While it’s difficult to measure (how do you quantify deals not done?), there is anecdotal evidence that the retail sector has felt the brunt of the CMBS decay more than any other sector.
Take a large mall or power center, for example. If it is truly Class A (newer, high sales), there are plenty of candidates to finance it, including insurance companies. If the asset is Class B, the options quickly dwindle. So who has that historically left it to? The CMBS shops. While this was the easy answer for the past decade, suddenly CMBS shops are eschewing these transactions. It’s because the B-piece buyers—who are driving the CMBS market these days—will kick out of the pool any retail asset that isn’t bulletproof. B-piece buyers yield this type of power since they are an oligopoly. And no bank or investment bank wants to be stuck with an unplanned 10-year loan on its balance sheet. So the easy answer is to decline any questionable Class B retail asset. What makes them questionable? Obviously, low sales. However, certain anchor tenants (regardless of sales) have become toxic to lenders because of the risk of anchor tenant bankruptcy, however small, as such an event could have a cascading effect on the co-tenancy clauses of other tenants (i.e., they can simply break their leases if a major anchor or anchors leave).
The CMBS market survived the Circuit City and Borders Books debacles, but doesn’t want to relive that experience. The recent woes of Sports Authority and the failed merger of Office Depot with Staples are causing bad déjà vu for lenders. In the malls, JC Penney and Sears are quickly going from “not preferred” names to “non-starters” if you want a CMBS loan. Macy’s recently reported that sales fell by over 7 percent in the first quarter versus last year, which caused its stock price to plummet. Kohl’s posted an 87 percent drop in profit while J.C. Penney’s sales slipped 1.6 percent. Even stalwart Nordstrom saw sales fall 1.7 percent in the first quarter due to weak customer traffic.
What retail deals are getting securitized? A joint offering from J.P. Morgan Chase and Deutsche Bank (2016-C2) securitized the senior tranche of the Quaker Bridge Mall in New Jersey as well as a portion of the Williamsburg Premium Outlets in Virginia, both for Simon Properties. BlackRock was the B-piece buyer and attained swaps plus 625 basis points on the BBB minus-rated tranche. A joint offering from Morgan Stanley and Bank of America (2016-C29) securitized a tranche of the Grove City Premium Outlets in Pennsylvania and a portion of the Penn Square Mall in Oklahoma City, again, both for Simon Properties. Rialto Capital was the B-piece buyer at Swaps plus 660 bps for the BBB rated tranche. The message is that if you’re Simon Properties, there isn’t much of a problem accessing the CMBS market, but even Simon is vulnerable. In a vintage CMBS pool (MLMT 2004-BPC1), there was a 77.5 percent loss for the bondholders on the A-note of the Washington Square Mall in Indianapolis, which was 24.3 percent of the entire deal.
There are a few positives though. While the department store sales outlined above were awful, retail sales as a whole rose 1.3 percent in April. And in an odd benefit, the recent difficulties in obtaining construction loans, due to the new reserve requirements for banks, is causing developers that were considering building a new shopping center to delay their projects. So absorption in older existing centers will benefit.
The takeaway? Financing retail centers will get more expensive and will require more equity going forward. The end result could be upward pressure on cap rates on parts of the sector.
Dan Gorczycki is a senior director for Avison Young where he places debt, raises equity and arranges joint ventures.