Lenders are grappling with a multimillion-dollar question: How are worries regarding rising online retail sales affecting real estate underwriting criteria?

The lending community has just cause to be concerned with the negative impact of e-commerce on bricks-and-mortar real estate. Consumers in North America are expected to spend nearly $37 billion shopping online this year, more than double the $14.9 billion spent in 1998, according to a study conducted by Boston Consulting Group.

"Of any of the product types we're looking at now, retail is probably the one we're being the most cautious about, and that relates a lot to e-commerce and what the effects on the centers are going to be," says Mark Witt, assistant vice president in the Chicago office of The MONY Group, a financial services company.

"It's hard to say how much of an impact there has been at this point, but it does make us more conservative in how we look at potential real estate deals," Witt adds.

Larry Hadley, mortgage banker and president of Hadley & Associates in Novi, Mich., echoes Witt's sentiments.

"What I think e-commerce is doing in some quarters of the lending community is inducing a little bit of caution," says Hadley.

Lenders financing real estate must be sensitive to the macro and micro trends that affect users of real estate. "If you're financing retail real estate," Hadley says, "then you as a lender are looking with some degree of concern to the impact of e-commerce on retail properties."

Who's most vulnerable? Retail properties receiving the most scrutiny for their perceived risk are power centers. "When you look at category-killers in the retail world, what they do is aggregate commodities that are not sold with high degrees of services," Hadley says.

The top five items purchased online are compact discs, books, computer software, computer hardware and airline tickets. Many lenders worry that those sales will have an adverse effect on traditional power center tenants such as Best Buy, Circuit City and Barnes & Noble.

Not only are such category-killers competing with online concepts such as amazon.com, but they have launched their own Internet sales initiatives to compete for those online shopping dollars.

Established national retailers ranging from Walgreens to Toys 'R' Us are not likely to be driven out of business by online retailers. Still, with more retailers shifting more of their focus to Internet sales, many real estate professionals are left wondering how that strategy will affect a retailer's commitment to physical stores.

Some lenders have altered the focus of their portfolios by minimizing their investments in power centers. "I won't say we don't do power centers, but we haven't really looked at any financing opportunities in that sector over the past six months or so," Witt says.

Instead, lenders such as The MONY Group are focusing on the comparatively low-risk, grocery-anchored centers that also house service retailers such as beauty salons, dry cleaners and video stores. "We are kind of steering away from the non-grocery-anchored centers," Witt says.

Apparel is viewed as another lower-risk sector simply because most people prefer to try clothes on before they buy.

Playing it smart While e-commerce may be prompting more lenders to use caution in retail underwriting, lenders are by no means ready to eliminate power centers from their portfolios.

"There is a heightened level of sensitivity to the issue. We acknowledge the e-commerce risk, and we're trying to underwrite these investments to meet that risk in determining our loan amount,"says David Graves, vice president of real estate and mortgages at State Farm Insurance Cos. in Bloomington, Ill.

State Farm is becoming more conservative on its loan-to-value and debt-coverage ratios to protect its investments from a potential downturn in the retail sector due to rising online sales. "What we have done as a lender is to be more conservative and seek a higher return on investment to compensate," Graves says.

State Farm focuses its retail lending efforts primarily on grocery-anchored centers. However, despite its strategy, State Farm recently invested in three power centers.

"We do believe that people still like to shop and still like to congregate in retail locations," Graves explains. "So we try to be selective in quality and location of assets in established yet still-growing locations - primarily suburban locations."

Although Graves declines to name the project, the most recent power center deal is located in one of the fastest growing areas in Atlanta where per capita income is extremely high. The large power center is home to major retailers such as Home Depot, Old Navy and Wal-Mart.

"We felt comfortable because of the location, the buying power of the area, the growth patterns present, and the fact that so many financially successful tenants had located there," Graves says.

Back to the basics State Farm prefers to finance power centers that are well located and possess a strong tenant mix and favorable demographics. Only when those criteria are met is State Farm comfortable in originating a conservative loan, Graves says.

The company also analyzes rent rolls and tenant-credit history before proceeding with a conservative capitalization and loan-to-value ratio to calculate the loan amount. In addition, State Farm incorporates a conservative debt-service-coverage ratio into that loan.

State Farm attempts to structure its loans so that the borrower could sustain a tenant loss and still meet its debt-service obligation without any problem.

Explains Graves, "We expect volatility at some level, but we try to write around that."