This should come as no surprise. With retail sales soft and some chains looking like they could be the next Kmarts (see story, page 12) lenders are getting a lot more finicky. Net lease lenders are stepping up due diligence and tweaking deal structures to account for the deteriorating credit profiles of many potential tenants.

“With more than 300 million square feet of dark retail space, declining consumer confidence, a weak Christmas season and uncertain outlook for 2003, there is certainly pressure on the retail market,” says Bill Pollert, president of New York-based Capital Lease Funding.

Last year, the ratio of retailer downgrades at Standard & Poor's outnumbered upgrades by two to one. Gerald Hirschberg, director of credit market services for the New York-based rating agency, estimates that average retailer credit ratings slipped from an investment grade rating of BBB- in the late 1980s to a non-investment grade average of BB or BB- today.

Less than one-third of the 129 U.S. retail firms S&P tracks qualified as investment grade tenants as of January. And the downward spiral is likely to continue as credit retailers post, on average, significantly declining Z-Scores (see Got No Street Cred, page 44). Although the slumping economy is partly responsible for the slide in credit ratings, the problems may not be solved by recovery alone: More than 25 percent of all retailers are on rating agencies' negative watch or negative outlook lists compared to the 10 percent that are on positive outlook.

But while the credit crisis has heightened caution among net lease lenders, it hasn't restricted investor interest in a sale-leaseback market that typically exceeds more than $6 billion a year in transactions across all property types.

The credit gap

Still, companies that are on the cusp of investment grade may have a harder time finding deals. And the bulk of tenants are in the tainted BBB- and lower zone. Among tenants that may face challenges due to credit ratings are Bed Bath & Beyond with a BBB- rating, Barnes & Noble at BB and Shopko Stores with a BB- rating from S&P.

Lenders are more closely scrutinizing lower level investment grade tenants as well as non-investment grade deals. Newly stringent due diligence standards look beyond big names, industry tenure and good concepts to analyze operations. “From our point of view, we have always really dug into the credit,” says Ethan Nessen, a principal at Boston-based CRIC Capital. “The scary part is that even digging into the credit of a tenant, a lot of people have been wrong.” That's why people were stuck with leases from Kmart.

In addition to relying on in-house credit analysis, net lease lenders are closely analyzing the underlying real estate. “I don't think the slippage in credit is affecting the ability to finance deals, but once you go below investment grade it is completely a real estate deal,” says Bruce MacDonald, president of Boston-based Net Lease Capital Advisors.

Lenders recognize the real possibility that a store could go dark, leaving them with the responsibility of re-tenanting the space. “The days where a company could say, ‘OK, here's my portfolio, 50 properties, take it or leave it.’ Those days are gone,” Nessen says. In the old days, title or easement problems might have disqualified certain properties within a portfolio, Nessen adds. But now, lenders are kicking out properties based on geographic disadvantages, too.

Accounting for risks

Unless you're an A credit such as Wal-Mart or Target, expect less favorable terms than you had in the past. Just as lenders are strengthening due diligence standards for non-A credits, they are also limiting their access to maximum leverage and long-term, self-amortizing financing to the highest quality credits.

Capital Lease Funding offers a solution to lower investment grade and non-investment grade tenants with its 10-year credit tenant lease program that uses a 20-year amortization schedule. Moreover, it combines both credit and real estate analysis to permit maximum leverage — 95 percent loan-to-value ratio compared to 70 or 75 percent under a traditional 20-year structure.

Because the 10-year deal requires a balloon payment at the end of its term, however, it carries more refinance risk at the end of the lease than does a traditional net lease loan. “That is a way of dealing with the fact that the market does not like credit tenant deals, other than very high credit tenants,” Pollert says.

Ultimately, lenders are finding ways to get comfortable with the perceived credit risks whether through deal structure or diligent underwriting. Their reward is a crowded field of investors that have a voracious appetite for net lease deals — both investment and non-investment grade.

Net lease investors are accommodating these new risks, too: “Safe” investment grade deals are trading at a cap rate of about 7.2 to 8.5 percent, compared to non-investment grade transactions that trade between 9 and 12 percent. Overall, however, McDonald says, “Lenders' eyes are wide open and they are careful about the deals that they do, but there is plenty of money to do deals regardless of the credit.”

Got No Street Cred

There's only one word to describe where credit tenants currently seem to be headed: down.

Morgan Stanley analysts Matthew Ostrower and Alan Calderon recently measured the Z-Score of credit retailers for the third quarter. A Z-Score of 2.4 represents the threshold for bankruptcy risk. And although the weighted average Z-Score of credit retailers remains well above that point, at 5.58, that figure is significantly lower than the 7.47 score of the first quarter of 2001, when the analysts first published Z-Scores (Chart 2).

Ostrower and Calderon also broke out the Z-Scores of grocery (Chart 1) and non-grocery (Chart 3) anchors, tenants most likely to use net lease deals, from their list of retailers. And what they found is that the supermarkets are still relatively healthy despite Wal-Mart's increasing market share. Non-grocery tenants aren't faring as well, as Wal-Mart and other discounters sell competing products as loss-leaders. The biggest Z-Score declines among individual retailers, however, are restricted mostly to inline tenants (Table 4).

TABLE 4: Noteworthy Declines in Retailers' Z-Scores
Company 2Q02 3Q02 % Diff
Wilson's Leather 3.43 1.93 -43.7%
Freds Inc. 12.32 8.16 -33.8%
Children's Place 7.83 5.71 -27.1%
Whitehall Jewel 3.05 2.23 -26.9%
Trans World Entmt. 3.22 2.40 -25.3%
Party City 5.12 3.87 -24.5%
Kohl's 9.36 7.12 -23.9%
A C Moore 9.07 6.92 -23.7%
Elec Boutique 6.21 4.76 -23.3%
Factory 2-U 3.13 2.52 -19.5%
Harold's Stores 1.57 1.28 -18.6%
Michaels Stores 5.96 4.89 -18.0%
Talbots Inc. 7.47 6.25 -16.3%
Galyan's Trading 3.21 2.72 -15.3%
Toys R Us 2.81 2.38 -15.1%