There are a variety of quantitative and qualitative performance measures and industry standards that Moody's considers when evaluating the credit quality of a regional mall. The occupancy cost ratio is an important tool in analyzing regional malls because it helps determine if tenants are paying rents that are above, at, or below sustainable levels. Moody's uses the occupancy cost ratio in its analysis of mall properties that are frequently included in commercial mortgage-backed securities (CMBS) transactions that it rates.

To calculate the occupancy cost ratio for a mall, Moody's divides the aggregate costs of all comparable mall shop tenants by their aggregate sales. To determine comparable mall shop tenants, Moody's considers all tenants occupying up to 10,000 square feet of gross leasable area, or GLA, which have been in occupancy for at least 12 months. Department stores, junior anchors, movie theaters and kiosks are excluded.

The amount of rent a retailer is willing to pay for a particular store is ultimately related to its ability to generate sales and maintain healthy profit margins at that location. A prolonged decline in sales performance or an increase in mall operating costs, or both, may drive the cost of occupancy to an unsustainable level.

Generally, rental income from a tenant with a relatively low occupancy cost ratio is considered sustainable, and may indicate an opportunity for the landlord to push rents at lease expiration. Even if the long-term nature of a lease precludes the landlord from increasing rents in the near term, there remains an inherent buffer to absorb the potential risk of declining sales without the occupancy cost ratio exceeding acceptable thresholds.

Sales & Occupancy
Average Comparable Mall Shop Sales Per Sq. Ft. Occupancy Cost to Sales Ratio
Less than $250 9%-11%
$250-$300 11%-13%
$300-$350 13%-14%
Greater than $350 14%-16%

On the contrary, if a mall has a relatively high occupancy cost ratio, the landlord's ability to pass through rent increases over time may be vastly diminished. In fact, the rent may actually have to be reduced at lease renewal if the landlord wants to retain the tenant. Correspondingly, when retailers are forced to downsize and shutter less profitable stores, it is frequently those with higher-than-average occupancy cost ratios that are found on the closure list.

Among retail formats, malls have the highest costs of operation largely due to physical attributes, such as climate-controlled common areas, interior finishes and landscaping, as well as parking lots and parking decks. In addition, subsidized anchor tenants push up costs for mall shop tenants, since anchors typically comprise 55 percent to 65 percent of a mall's GLA but contribute only about 5 percent of gross revenues.

Although mall occupancy cost ratios for individual tenants vary by merchandising category, average ratios typically range from 9 percent to 16 percent (see table). If a mall's occupancy cost is above the acceptable range relative to its sales, Moody's analysis entails adjusting the revenues downward by decreasing the total base rent to the point where a sustainable occupancy cost ratio is achieved.

For malls generating sales at the low end of the range, Moody's has established lower thresholds for acceptable occupancy cost levels. As occupancy cost ratios for these lower-tier malls creep up into the teens, they have increasingly little margin for error and limited capacity to push rents as leases expire.

Conversely, tenants that are operating in the most productive malls are generally willing to pay more rent for the benefit of being located in top-tier properties with high sales capture rates. As sales per square foot increase, so do operating efficiencies, putting the retailers in a position to tolerate higher rents.

Moody's distinguishes between malls with low and high occupancy cost ratios because the former enjoy greater flexibility to withstand sales volatility. Consider this example of two malls, each with comparable sales of $300 per square foot. Assume that Mall A and Mall B have occupancy cost ratios of 11 percent ($33 per square foot) and 14 percent ($42 per square foot), respectively. Mall A can withstand a sales decline of $46 per square foot before reaching the sustainable 13 percent occupancy cost threshold ($33/$254 = 13 percent).

An alternate view of this scenario is that, by holding sales constant at $300 per square foot, Mall A may be able to benefit from any near-term rent expirations by increasing rents by an average of $6 per square foot, or 18.2 percent, to $39 per square foot, without exceeding the acceptable 13 percent occupancy cost ratio ($39/$300 = 13 percent).

On the other hand, Mall B reflects a scenario in which the property has no buffer in the event of a sales decline because the existing in-place occupancy cost of 14 percent is already high relative to sales. With costs of $42 per square foot, Mall B's sales will need to increase by $23 per square foot, or 7.7 percent, in order to achieve the acceptable 13 percent occupancy cost ratio ($42/$323 = 13 percent). To address this heightened credit risk, Moody's would adjust Mall B's rental revenues downward to a level that results in a more sustainable occupancy cost ratio.

To demonstrate the impact of an occupancy cost adjustment on Moody's sustainable net cash flow and valuation, let's look at Mall B once more. It has comparable sales of $300 per square foot and occupancy cost ratio of 14 percent. If Moody's estimated sustainable occupancy cost ratio for this mall were 13 percent, then it would be necessary to reduce its $42-per-square-foot rental income by $3 in order to lower the occupancy cost ratio from 14 percent to 13 percent. This adjustment results in a 12-percent reduction in stabilized net cash flow. Assuming this loan was underwritten to a 70 percent LTV and 1.51x debt service coverage ratio, our methodology, all else being equal, would result in a higher Moody's LTV of 79.5 percent and a lower debt service coverage ratio of 1.33x.

For a mall with low occupancy costs, Moody's adjusts the LTV sizing of senior tranches or adjusts cap rates downward in recognition of that mall's reduced inherent volatility.

Who Andrea Daniels with Patricia McDonnell
Daniels and McDonnell are vice president of Moody's Investors Services, New York.