The retail real estate market was buffeted by ongoing, countervailing trends in 2018. Online spending continued to erode in-store sales. In traditional malls, more “anchor stores” closed, dragging down the prospects of smaller retailers. At the same time, an increasing number of online retailers were implementing “clicks-to-bricks” strategies and opening stores.
Change will remain a constant in 2019, but banks and asset managers cannot afford surprises in their retail real estate portfolios. Close oversight of holdings and timely follow-up are essential, to avoid losses and seize opportunities. This article analyzes the implications of one of the biggest recent setbacks in retail and provides best practices to mitigate banks’ and asset managers’ risks in today’s uncertain environment.
The Sears Story: A Cautionary Tale
What if I told you that Amazon would be going out of business? Very unlikely, if not impossible, right? Well, not so long ago, that same sentiment applied to Sears.
Now, the 125-year-old retail giant is a shadow of its once dominant self, with an uncertain future. Sears’ fate reminds us all to “never say never,” and it sends a warning signal to banks and asset managers to proactively manage their commercial real estate holdings in a changing retail landscape.
For nearly 50 years, Sears sat atop the American retail landscape—an “anchor tenant” at many malls. With humble beginnings as a watch seller, it became a storied brand, with a national footprint and massive scale from both a product and cultural standpoint. Its catalog was a staple of the holiday shopping season. However, Sears now operates only about 800 stores, from a high of 4,000 at its peak, and is the subject of media speculation about a further decline.
Sears represents a microcosm of the immense change in the U.S. retail sector, which is having broad impact on the commercial real estate market. The new era of mobile and internet-based retail sales and delivery is sending continued shock waves through the more traditional “brick and mortar” retailers. Meanwhile, neighborhood centers, walk-up malls, outlet malls, and destination centers are generating better results than the old-style, traditional mall.
The Real Estate Impact
Sears has not been the first major U.S. retailer to struggle and is not likely to be the last. In the recent past, strong brands such as Toys “R” Us, Bon-Ton, Sports Authority, Circuit City, and RadioShack have all suffered setbacks in the new world of retail. Dozens of others have declared Chapter 11 bankruptcy and restructured.
When big retailers close a store, it has a ripple effect on the malls that count on these anchor tenants to drive customer traffic. Increasing vacancy rates make it hard for real estate owners to attract new tenants and shoppers. Rents drop, potentially triggering a death spiral. Many malls today are fighting these pressures, as traditional retailers continue to evaluate store closings.
According to Reis, a leading commercial real estate research firm, vacancy rates at regional and super-regional malls reached 8.6 percent in the second quarter of 2018. That was up from 8.4 percent in the prior period, and it represented a high not seen since the third quarter of 2012, when the vacancy rate was 8.7 percent.
Rental data also paints a negative picture. The average rent for malls in the third quarter of 2018 fell 0.3 percent to $43.25 a square foot, down from $43.36 in the second quarter, according to Reis. The last time rents slid on a quarter-over-quarter basis was in 2011.
All of this negative news stands in contrast to many of the macroeconomic trends in the country. Job growth, GDP growth, and consumer confidence are all up.
The largest traditional mall players in the real estate industry are changing with the times. The days of high-performing malls with two to three anchor tenants, predictable food-courts, and the usual in-line tenants have come and gone. Mall owners are trying to develop more entertainment-centric properties, as well as mixed-use centers including movie theaters, hotels, and other entertainment options. They are making their malls as attractive to shoppers as possible.
Best Practices for Banks and Asset Managers
From a risk standpoint, it is imperative for banks of all sizes to be proactive in monitoring their commercial real estate positions. While all of the traditional asset classes within the commercial loan space (office, apartment, hotel, storage, industrial, etc.) require constant and thorough oversight, the retail sector requires particular scrutiny, given the immense disruption in that sector.
As seen in the chart below, nearly half of all retail loans are held by banks (33 percent by smaller regional and local banks). The commercial mortgage-backed securities (CMBS) market finances 24 percent of all retail loans, with the balance being held by other players, including insurance companies.
To mitigate risk and determine the best course of action relative to your commercial real estate exposure, banks and asset managers should consider industry best practices including the following:
- Portfolio Review and Segmentation. Conduct a thorough review of your entire portfolio, codifying loans by asset class, risk weighting, unpaid principal balance, loan-to-value ratio, and other attributes.
- Exposure Analysis. Assess your portfolio relative to risk appetite, house limits, borrower credit risk, etc., highlighting potential loss holdings.
- Asset, Market, and Borrower Analytics. Codify your loans, with an emphasis on asset types, market and submarket dynamics, and borrower credit performance. Which loans are performing better, worse, or in line with expectations?
- Retail-centric Review. Do a deep dive on retail-centric loans and the underlying collateral; for specific retailers, determine whether stores are owned or leased.
- Lease Review. Consider an internal or outsourced lease review for major tenants within retail loans, abstracting and highlighting salient points within the lease contract. Look at how the tenant is performing, relative to expectations, including a cash flow analysis over the last 12 to 24 months, financial statement reviews, and analysis of other activity from the time you underwrote the property.
- Communications Plan. Create a transparent communications plan with borrowers as well as operators/property managers so that objectives are clear. Underperforming loans require a discussion of potential causes, such as new competitors or other market activity. A site visit could be in order. Loan performance objectives such as occupancy rates may need to be revisited and re-emphasized.
- Strategy Assessment. Devise a strategy for potential delinquency management, and various potential loan workout strategies. For example, loan documents typically include escalating follow-up in the event that a payment is late by 30, 60, or 90 days. Banks are averse to foreclosing, and so might choose to modify the loan terms in one of several ways, such as decreasing the interest rate, extending the loan, or forgiving a payment. If ultimately the loan no longer meets your risk tolerance, it may be time to trade it with a different institution or conduct a private or discounted sale.
- Property-level Analytics. Review any troubled retailer’s impact on a property, including metrics such as gross leasable area or percent of total rent. Where one retailer is doing well, others nearby tend to do well, and vice versa.
- Tenant Replacement. If necessary, create a marketing strategy for replacing a troubled retail tenant, including alternative uses for the space, as well as concessions necessary.
Nobody celebrates a foreclosure. Loans that default are expensive for all concerned—whether the retailer, mall owner, property manager, bank, asset manager, securitizer, or insurer. And while most banks and asset managers try to stay current on all loans and holdings, the retail market has repeatedly shown its ability to deliver negative surprises. Staffing at banks and asset management companies can often fall short, leading to a slower reaction time. This can be particularly risky in today’s fast-changing market.
Closer, more thorough, and timelier analysis could be the determining factor for many banks’ and asset managers’ retail real estate portfolios in 2019.