Below is the edited version, which appeared in the magazine's April 2001 issue.
Experts share their ideas on trends in retail finance — and the trajectoryof the industry in a slowing economy.
During the Mortgage Bankers Association of America Convention (MBA), in San Diego, Calif., in early February, SCW's editor, Elise Vachon, moderated a round table panel featuring some of the finance industry's top experts.
During that discussion, these accomplished financiers graciously shared their views on the United States being over-retailed, the reasons why, the slowing economy, the recirculation of excess inventory and positive, emerging trends.
FITZPATRICK: We have all seen statistics in what's going on in terms of jobs and interest rates, and they seem to be surprisingly good, even though the trend may be toward the slightly more conservative. It's easy right now to paint the retail sector with a big black brush and say "stay away."
Retail is in trouble. It's probably an opportunity. You can really pick your spots and probably make a little more money.
SUBLETT: The retail finance sector is our largest concern. We are seeing shrinkage as far as big box retailers and I am very concerned about the ripple effect. It's going to impact the overall stability of markets when there are so many vacant buildings. There are only a finite number of users for some of these boxes. We must ask how long is it going to take to fill them and at what rental rate?
VERRONE: You have got to pick your spots. If you know the operator well, you like his plan and there is a lot of credibility, you like the location and like the tenants, it's worth the risk. I don't think this is a time to take huge bets in retail.
BURKHALTER: There definitely is excess inventory to be recirculated; either building improvements or land. If we are in a zero-growth economic mode, that's going to translate to weaker sales and weaker profits and weaker balance sheets. We have seen some trends in credit downgrades by quite a few retailers.
There is also a noticeable gap in cap rates. We are seeing a sizeable difference in interest by the capital sources between the first tier- and grocery/drug-anchored centers, and then everything else.
We have definitely seen quality affected because we're over-retailed. There are going to be some very interesting niche players that are going to fill that void. Bankruptcy is a major issue. We just closed a $45 million permanent loan on a center anchored by a grocery store, drugstore, bookstore and theater. Two weeks after we rate-locked the, the theater filed for bankruptcy. It's not if someone is going to file bankruptcy, it's who is going to file bankruptcy.
The advice I give to the developer is "thou shalt only ground lease to theaters." That really saved the bacon on this deal. It's going to be a real challenge for retail developers going forward — how are they going to anchor these entertainment centers? I think that's going to be one of the biggest challenges in the recycling of real estate.
FITZPATRICK: We have been very tough on theaters in our underwriting, maybe overly conservative. But they have a ripple effect, particularly to the entertainment centers. We had one where we closed the loan, and they did file in the process, but they went back reaffirming their lease, and it's going to be okay. But the lease dramatically changed through payments.
SUBLETT: And are you going to try and securitize that loan?
FITZPATRICK: Oh, absolutely.
SUBLETT: And what do you anticipate the response will be?
FITZPATRICK: Hopefully we picked a spot with a good store behind it investors will like. That's what we try to do. If you close loans the investors don't like, your long form is forever. That's not our mandate. So you have got to be very conscious of that.
SUBLETT: I have a loan down in Florida on a retail center with a movie theater that's 38% of the revenue, not huge. Bottom line is if that property won't provide a 1.0:1 debt service coverage without that movie theater, it's out. And that's the approach we find the bond buyers taking. Therefore, that's the approach that we're taking.
If we have got someone on the undesirable list, a high risk of bankruptcy or store closures, the deal has got to underwrite with at least a 1.0:1 without them, or we are not going to take the risk.
VERRONE: I think fitness centers kind of fall in the same category. The worst thing is when someone sends you a retail center anchor, a Regal Cinema on one side and a health club on the other, it's tough.
BURKHALTER: One of the problems for the movie exhibitors was there really were very few blockbuster movies last year, and it did affect their sales. And it's kind of a shame that they did overbill, because from financing a lot of retail every year, first it was dot.com retail, online, then it moved to clicks and bricks which is probably a pretty good combination we see. Barnes & Noble is a classic example of what will be a very successful bricks and clicks retailer.
But soft goods retailers are most vulnerable. The entertainment centers are probably least vulnerable to Internet commerce.
BURKHALTER: To close a loan where the theater went bankrupt, we actually had to go back out in the market. We thought we did our traditional radius demographics and the competition of other anchored centers. But we had to go back out and do some primary research about radius for all the different theaters. And we really put them in two categories: stadium and non-stadium. We found out that we had no competition as far as stadium seating within a two- or three-mile radius. And that really helped.
SUBLETT: You can argue and you can build your data, but I think you are going to lose. The BP's (basis points) buyers are controlling the market. The general approach nowadays is, we have so many bullets, and there are deals that may have all the data stacked up, but if it fits a profile, they are going to use that opportunity to kick it out.
VERRONE: We are stuck. We have a loan from 1998, a Regal, 20 million bucks, 98% LTV, 20-year loan, 1.00 coverage. That's the worst of the worst.
BURKHALTER: Robert, when you said 1.0:1 coverage, were you underwriting them as a credit deal?
VERRONE: As a CTL, yes.
SEALE: Exactly. That's one of the misnomers in the market. You can always talk about credit tenant. Fortunately, the first part of that is credit, and clearly Regal was never there. The sector got themselves in trouble, right?
You can have either operating problems or bad balance sheets. They grew and ended up in bad capital structures they are now all having to pay the price for.
I think you'll see a shake out. But it's almost to the point that if you don't file bankruptcy as a theater, it's a bad strategic move, because it's now an opportunity. It's almost expected in the industry. It's an opportunity to get yourself out of the weight of some of this excess debt. And after that's done, then the strong operators will continue, and they will be important strategic assets, just like the bookstores.
BURKHALTER: I think we are already starting to see some healing. I think some investors are buying other chains, consolidating them and recapitalizing those companies. I mean they need to do whatever it takes — the bargain basement; cents on the dollar; the right discount.
The sooner those discounts are marked, the sooner the industry can move on. I can't tell you how many developers have told me that not filing bankruptcy is almost a hindrance because they can't shed their poor inventory.
SEALE: They need to get the problem behind them.
VERRONE: Every morning when I log in, I get an e-mail of what company has filed for bankruptcy and shops going to close.
FITZPATRICK: I think retail will be better than people think after these closings.
FITZPATRICK: Montgomery Ward closed, and so did Bradlee's. These are big names that have been around for quite a while but were doing badly.
SEALE: I actually think those are healthy closings though for the state of the retail world, because it's the survival of the fittest. Right?
SUBLETT: Drive a stake through them. Instead of having a Montgomery Ward linger and linger and linger; we knew that it was done.
BURKHALTER: Long overdue.
FITZPATRICK: It is interesting, because we are working on a mall right now. It was a Montgomery Ward which went, and it was quickly replaced with a Kaufmann's. Great operators. This is such a good thing for this mall. Montgomery Ward was just flailing along.
FITZPATRICK: Cleansing is a good thing, because you are going to lose some peripheral pieces of business that probably shouldn't be there anyway. Kaufmann's is a great example of it. It's interesting to walk the anchors, like Penneys. I was in there two minutes before a salesperson walked up to me. Two minutes! You walk into some of the other stores that are now online; you couldn't even find salespeople. To me that is very interesting from an underwriting perspective. I always do that.
BURKHALTER: An emerging trend with some of these retailers is something they picked up from Wal-Mart — greeters.
FITZPATRICK: People like it, and it gets you from thinking of buying to actually making a buying decision. It's very interesting to see.
BURKHALTER: Having a good retail experience is becoming much more important. If you buy Levi's over the Internet, you don't care if you are buying them from somebody in India. If you find them cheap, it's a commodity.
But the retail experience must be a good one and only people can make it that way. For example, if you hit a new project for one of our key developers, the valet parking people must say, "Mr. Fitzpatrick, have a good time at the center." And that's not something you are going to forget.
FITZPATRICK: I think retail is going to be good. People are going to defer buying a new car, a new house or a second home. But they are going to go to the mall, buy a T-shirt, a new pair of pants, probably a new TV … I'd be worried about the auto business. I think those guys are going to have a really bad year.
BURKHALTER: We have advised some of our investor clients to stay with the grocery/drug anchors. You may have to pay a lower cap rate, but going into a softer economy, we are a bit spoiled. We have had eight or nine years of great growth, so a little down tipping …
BURKHALTER: Home furnishing centers, I think that's one of the weaker things, because they're one step away from the auto and the appliances.
SUBLETT: I think we'll see theside slow. I don't work in what I call the bank side. I'm on the construction side, but I definitely think the construction side is going to slow. And that will be a good thing for the existing properties.
You just have less inventory. Those that are there will focus on increasing their same store sales, and we'll see a little bit of stabilization as opposed to continued rapid growth. I think that's a good thing.
BURKHALTER: I am very optimistic in short-term and midterm as far as the availability of permanent debt capital for retail particularly on the securitized lending side. The Fannie Mae and Freddie Mac agencies have a huge market share on the multi-family side, and the insurance companies are continuing to do a very good job of financing industrial, five-year leases that are leaning into the market.
So what product types does that leave for the C&B side? It leaves office and retail. I think those are going to continue to be a very important product type for the securitized lenders.
VERRONE: I think Fannie and Freddie on the multi side do have an advantage, but it was interesting that Fannie did 14 million of multis and conduits of 14 million of multis, so I think we are still going to get plenty of that paper.
But, yes, retail and office is where it's at, where you get a little bit of a deal and take good bets.
SEALE: It's still very tough to get into the prime New York restaurants. Until that stops, we are not in a recession. People are clamoring to pay whatever for the meals.
HANTGES: We have a very large allocation this year, close to $400 million for bridge loans. We are getting very interested in the retail sector, so it is an exciting time for us.
Incidentally, in Las Vegas, the Desert Passage, which is hooked in with the Aladdin Hotel, is having difficulty, they aren't getting the sales per foot. One of the reasons is they don't have any great anchors.
VERRONE: There is a center in Charlotte that's doing great. I'm just curious if it's going to continue to do so. It's in a great location in an affluent area. But there is a golf store where the average golf shirt is 400 bucks and socks are 50 bucks. Those stores are going to drop down — but the grocery anchored stuff is going to be fine.
HANTGES: When the market moved away from grocery anchored to entertainment, it went into a market less reliant on staples. And that's why today people like grocery-anchored centers, because they know it's going to get used, and it's not going to go away if the economy slows down.
We should ask ourselves if a fad will be sustainable financially during falling economies. For us as a bridge lender, the retail environment right now really lends itself to big opportunities — good bridge loans to quality borrowers and quality projects.
If you have a project that doesn't fit into any conduit programs, but you know you have a borrower that has the financial wherewithal to keep their property regardless
You simply make some judgments based on who the borrower is, how long they've been around, what their resume says about them and their personal financial statements.
SUBLETT: As an interim lender, opportunity lender, do you have a concern that you are lending into a declining or deteriorating market as it relates to retail? And that if it is on the down side, now is not the time to get in? The thought would be wait until it bottoms out. And do you see further shake out?
HANTGES: Typically, on short-term loans you are making decisions on individuals or on their capacity to hold their properties if they wind up with some short-term difficulties.
If an anchor closes, what happens to the rest of the center? That's why we too like grocery-anchored centers. We try to get in there at 65%, 75% loan-to-value. But we also try to get additional collateral. We can help that borrower solve a problem, but we can also be secured.
When you do conduits, additional collateral is somewhat irrelevant. So you make your underwriting decision based on the property, but we can make our underwriting decision based on the resume of that borrower.
FITZPATRICK: By the time we get involved the project is built. More often than not we have to have an operating history to make a decision. We do securitized lending and are driven a lot by what rating agencies think. It's interesting we all use the rating agencies for information.
We all look at the person who is actually developing — absolutely critical. The guys who are new, haven't been through that cycle, we try to stay away from them. We like those guys with experience; 15 years is a great number. You have got to know the guy's seen it. He's been through it. He's not going to pick a stupid location. He's not going to put in bad tenants.Roundtable participants
- Robert A. Verrone
Commercial Real Estate Finance
- Clay M. Sublett
Senior Vice President
Key Commercial Mortgage
- David L. Reavis
Lead Specialist, Communications
- James M. Fitzpatrick
- Shawn P. Seale
Senior Vice President, CFO
- Tom A. Hantges
- Kevin J. Burkhalter
Senior Vice President
Johnson Capital Group Inc.