Featured ExpertOur Perspective 9/ 6/ 2017

Interest in Retail Investment Remains Strong Despite Changing Fundamentals

Despite news of struggling retailers across the country, financing for retail assets remains attractive to many lenders—providing borrowers many options to secure the right financing. Store closing announcements from iconic retailers such as Macy’s, J.C. Penny, Sears, Kmart, Foot Locker, Office Depot and Abercrombie & Fitch are up nearly 100 percent since last year. Others have filed for bankruptcy, including PayLess Shoe Source, Radio Shack, and The Limited. The majority of retailers closing stores are typical mall tenants: department store operators and apparel and electronics sellers.

Some of those closings are offset by a 20 percent year-over-year increase in store openings. It’s unclear if there will be enough demand to fill all the newly empty spaces being returned to the market, but some chains are trying. Dollar Tree plans to open 650 new locations; supermarket operator Aldi plans 130 new stores; and TJX Cos. plans to open 111 TJ Maxx or Marshalls.

California’s retail vacancy rates have been relatively unchanged since 2015. The seven major markets in California, comprising over 261 million square feet of space, posted an average overall vacancy rate of 6.5 percent for the last thirty months. During this time the rate has not increased.

Store closures and bankruptcies can partly be attributed to the U.S. deflationary environment over the past two decades in which goods were cheaper to produce and sell to customers; and record low interest rates allowed many retailers to expand store counts quickly into suburban malls. Additionally, Amazon and other e-retailers are cutting into the brick-and-mortar sector more than ever before. Amazon commands 25 percent of incremental retail sales growth year-over-year, once gas, food services, automotive and auto parts sales are removed. Amazon’s announced acquisition of Whole Foods will have a significant effect on the grocery industry, which will impact retail centers.

Nevertheless, while e-commerce has hurt some more traditional retailers, opportunities exist for companies that can compete both online and on the ground to offer consumers the ultimate in convenience. Retailers with an existing store network have the advantage of providing both online offerings and a traditional shopping experience. Walmart is one such example with considerable increases in both same-store-sales and e-commerce sales. Some companies who started as exclusively e-retailers are complementing their online business by opening physical stores.

INTEREST IN FINANCING AND INVESTING IN RETAIL REAL ESTATE REMAINS STRONG
Despite the turmoil in the retail industry, life companies, CMBS lenders, banks, debt funds, and other lenders continue to provide permanent, bridge, and construction financing for retail properties.

However, lenders are scrutinizing deals more thoroughly and employing tighter underwriting standards. There is more focus on analyzing the location, credit profiles of anchors and major tenants, occupancy history, tenants’ sales figures and occupancy costs, competitive properties, and potential for future development and property design to ensure a high probability of re-tenanting. Lenders are also more thoroughly analyzing sponsors and seeking those that are well-capitalized with a successful history.

During the past year, NorthMarq Capital has secured over $800 million of retail financing in California and over $2 billion nationally. These transactions have included grocery-anchored centers, lifestyle centers, power centers and strip centers.

In addition, our loan servicing portfolio does not suggest a trend of retail properties faltering. NorthMarq
currently services approximately 1,300 loans secured by retail properties. Of these loans, only three (0.2 percent) are non-performing. The following San Diego office case studies illustrate the demand for retail real estate:

Development Project
NorthMarq secured $44 million in financing from a bank that provided the construction loan and a correspondent life insurance company who provided preferred equity. The 125,000 sq. ft. project in a strong suburban location was 60 percent preleased to investment-grade tenants on staggered long-term leases. The challenge in financing the center was meeting the high equity requirement of the bank and the HVCRE regulation, which requires 15 percent in cash equity. Multiple banks were interested in the construction loan with loan-to-cost (LTC) parameters that ranged from 60-70 percent. The preferred equity investment assisted in providing the cash required to meet the HVCRE regulation. The term of the construction loan was for two years followed by an option to extend for three years. The bank’s underwriting was based on a 65 percent loan-to-stabilized value and 70 percent of cost.

Privately-Held Grocery-Anchored Center
A life insurance company, for whom we are a correspondent, provided a $28 million (65 percent LTV), 10-year, loan amortized over 25 years to refinance a grocery-anchored center. The loan, with a 4.3 percent rate, was structured with a fixed declining prepayment premium. The challenge was that the grocer is privately held with a small number of stores. The only other major tenant is a non-credit thrift store. The balance of the rent roll is small, non-credit tenants, with an average store size of 2,500 sq. ft. Despite these weaknesses, the property benefits from a strong corner location with a 50,000 ADT, 98 percent occupancy, strong submarket and demographics, and the grocer’s occupancy cost is four percent. Few lenders were interested in this deal, but one saw enough positive attributes to overcome the perceived risks.

Shadow-Anchored Center
A life insurance company, for whom we are a correspondent, provided a $38 million, 15-year loan amortized over 25 years at a 3.61 percent rate to refinance a 100-percent-occupied suburban center. The center is 60 percent leased to credit and national tenants and shadow-anchored by major national retailers. Although life insurance companies have a strong appetite for retail product, the challenge with this deal was that the anchors are not part of the security. This created a disproportionately high loan per square foot, which is a challenge for life companies. The loan represented over $350 per square foot.

In order to overcome that challenge, we demonstrated the strength of the deal, including its central location in a high-quality, master-planned community, strong sales history, 53 percent loan-to-value, strong demographics, two percent submarket vacancy, and strong and experienced sponsor.

Acquisition and Repositioning
NorthMarq arranged a bridge loan for a vacant big-box building on behalf of a client that has a long and successful track record of repositioning retail properties. The 125,000 sq. ft. building was formerly 100 percent occupied by an owner-user retailer who decided to relocate. The Sponsor had a national retailer in tow with a below-investment-grade rating, representing 40 percent of the building. The challenge came from the orientation of the building, which had storefronts that did not benefit from direct visibility and exposure to the highly-trafficked corridor. Also,  many lenders questioned the ability to lease the vacant space due to the abnormal bay width-to-depth ratio.

We submitted the deal to 10 lenders and only one lender provided firm terms. The $7.8 million nonrecourse loan (75 percent LTC) included an initial funding of $5.3 million with the balance reserved for the interim operating deficit and tenant improvement and leasing commissions. The sponsor has since fully leased the building.

There is plenty of capital available for a variety of retail property types with the right mix of attributes. Borrowers should be prepared for the leverage, rate, amortization and required structure for such things as tenant improvement and leasing commission reserves to be commensurate with the quality of the deal. We expect lenders to continue to invest in this important asset class even as the retail industry goes through this transformation.