Small wonder the shopping center industry is holding its collective breath. Retail sales slipped further than had been expected during April and May. That's the bad news, for retailers. The good news, in a financing context, is that it may help stabilize recent spikes in interest rates.

Then again it may not, depending on whether other bellwether sectors of the economy stay in overdrive. Meanwhile, lenders are rethinking their strategies about shopping centers.

Simon Ziff, president of New York-based real estate capital advisors Ackman/Ziff Real Estate Group LLC, reports his company is doing mainly supermarket-anchored center acquisition financing. "There is more opportunity in that activity than refinancing them," he explains.

But even the company's acquisition deals are off slightly because interest rates have been hovering over the past year in the mid 8%s, compared to the relatively cheap money of a low 7% range.

Refinancing deals dried up "Most borrowers utilized the window of opportunity over three years to the end of 1998 to refinance their centers with a higher leverage than ever achievable before, with longer amortization than achievable before," Ziff notes, "and locking in rates and terms for 10 years. That nearly exhausted the supply of potential refinancing. Some of it has come back but not at that volume," Ziff says.

When there are "tremendous lending volumes, sooner or later the spigot is turned off," comments Joseph Hevey, a senior director in the Dallas office of Houston-based Holliday, Fenoglio, Fowler LP. Right now, it seems that the spigot has been turned down, if not off.

Sales of centers are down as well. "The investment community isn't buying at a price that sellers are asking, so those transactions have diminished substantially," Hevey says. Lower sales activity and a sharp decline in refinancing have depressed shopping center financial activity "tremendously, probably as much as 40% or more," according to Hevey.

Hevey's mortgage banking firm describes itself as the largest third-party intermediary in the United States - representing developer/owner borrowers and life insurance, pension fund, lenders, etc. Last year it transacted about $12.3 billion worth of real estate.

"The market is tough," agrees Paul McDowell, senior vice-president of New York-based Capital Leasing Funding (CLF), "but we're not in as tough a position as typical capital market-based conduit lenders, because our market is almost entirely a steady supply of new product with investment-grade tenants, and not as much subject to the cyclical nature of product in the refinance market."

Don't count out CMBS However, refinancing centers in the commercial mortgage-backed securities (CMBS) conduit market will likely come back beginning this year, when mortgage loans transacted 10 years ago and longer start rolling over, he added. Centers in this category are typically 10 to 15 years old.

Refinancing can also cross over into rehabilitation financing territory - or a short-term permanent loan for a shopping center that is being repositioned.

CLF mainly finances new centers (about $2 billion worth last year) with long-term net leases to investment-grade credit anchor tenants, McDowell says.

New York-based Parallel Capital LLC is in the CMBS conduit market. Executive vice president Rob Schneiderman says developers or shopping center borrowers can "generally can obtain good leverage from lenders like us at competitive rates. We sell long-term fixed and non-recourse loans and expect to do about $350 million this year, a quarter to a third of it in the retail market."

In the meantime, the CMBS conduit market continues its steep plunge over the past two years. Joe Cunningham, president of Sacramento, Calif.-based Liberty Mortgage Acceptance Corp., (more than $200 million a year in loans) notes that the volume of these conduits dropped to $66 billion last year from $80 billion in 1998. Hevey says it could drop to $45 billion this year.

>From nowhere to $250 billion "The CMBS came from nowhere to more than $250 billion in outstanding debt," says Cunningham, "which is a significant part of about $1.4 trillion of commercial real estate debt outstanding in the United States." He characterizes CMBS conduits "as a successful model which has performed well, with little delinquency. That bodes well for capital availability in this marketplace."

His company is "bullish about the retail market," he says, "and would like to increase our penetration in neighborhood shopping centers and drug store/supermarket-anchored product."

Meanwhile, Cunningham says shopping center owners are holding off and waiting for better interest rates due to uncertainty about rate fluctuations, even in an attractive treasury market.

Fluctuations in interest rates do not deter everyone in the industry. Kevin Burkhalter, senior vice-president of Los Angeles-based Johnson Capital Company, a real estate capital advisory firm, says there is some opportunity over the next three years for the fixed rate to drop.

"Some owners feel an 8% interest rate is still several percentage points below an unleveraged return on costs, and like to lock in that profit between an 11% return on cost and 8% cost of capital, lest fixed interest rates rise further and erodes their profit margins.

"Some of our clients are saying they're not in the business of predicting interest rates, that they're in real estate and it's enough to be good at that. They say they're not a hedge fund, not an arbitrage group, and if today's rate works because of the spread, we'll do it now," Burkhalter adds.

Lending squeamishness Schneiderman says the higher rate environment has curbed acquisition and refinancing volume compared to last year. "There is a popular notion that all pent-up demand has been satisfied and inventory that needed refinancing has already been accomplished. Lenders are also developing a bit of squeamishness about smaller unanchored retail properties in secondary locations," he comments.

Some lenders are doing equity deals with shopping center owners. Would Schneiderman's company be tempted? "We'd look at equity deals, depending on what the balance sheet looks like and the source of funds," he answers.

He would also look at entertainment-oriented centers, providing the major tenant was a multi-screen theater. Schneiderman would also prefer the center to be integrated into more conventional centers, rather than a free-standing unit.

Ziff's company, which arranges financing for nearly $500 million worth of shopping centers a year, is turning to equity deals to become what he calls a "major part of our business, on which we're probably spending 75% of our time", drawing on the partnership appetites of foreign sources, pension funds and high net worth investors.

He says REITs are also finding that the equity route through a private placement with a partner is an easier way to raise money than in the public markets. The difficult part is finding the right partner in a highly structured deal.

Where is it heading? Hevey says grocery-anchored and single-tenant big box retailing is still alive and doing reasonably well, particularly in high growth residential neighborhoods like the Dallas/Fort Worth suburbs.

Sales of centers have not died, and since the buyers aren't typically paying cash, there is some room for financing these transactions.

Burkhalter notes that the current cost of capital is not eroding or enhancing owners' yields. "It becomes a challenge when a permanent lender wants either 30-year amortization or 25-year amortization. At an 8% interest rate, a 30-year amortization works out to about a 9% loan with constant principal and interest. From a pure cash flow standpoint that's called negative leverage.

"One way to remedy that is based on rent increases over the next two years," says Burkhalter. "We are convincing some lenders to write an interest-only period, for one to two years, so the loan constant is back at 8% and cash flow is maintained. By the time 25 or 30-year amortization kicks in, a year or two away, the owner has rent increases which can offset the increase in debt service."

Refinancing loans will be broadened into overall permanent financing among first-time owners. Ten-year-old loans originated in 1990 and 1991 will be repackaged to take out construction loans.

Grocery- and drug store-anchored centers with 20 to 25-year leases, regional malls, and entertainment centers will be high on investors' portfolio shopping lists. Power centers will be low on those lists and strip centers will sink to the bottom, Burkhalter added.

When asked what lenders are looking for at this point, Schneiderman replied: "A combination of credit, strong sales year over year to make sure they are growing, not declining, and a staggered lease rollover profile so they don't have a preponderance of leases rolling over in a particular year, which needs fairly heavy reserves to accommodate."

Credit tenant lending is applied mainly to big box retail, drug stores, or stand-alone net lease properties. Credit net leases are 15 years or longer and the tenants must have an investment-grade BBB or higher credit rating, as measured by Standard & Poor's or Moody's rating services.

Credit tenant lending allows for higher loan-to-value ratios and debt coverage ratios. A center two or three years old with a high degree of credit leases will attract more lenders than a similar one with little or no investment-grade credit, although in the latter case the center can offset that disadvantage if its location and sales are strong.