What a difference a year can make. In June 2007, just over one year ago, a borrower could obtain from a conduit a loan at 80% to 85% loan-to-value (LTV) for a retail center, with 10 years of interest-only payments and at a spread of 100 basis points (bps) above the 10-year Treasury yield.
Today, of course, because conduits are sidelined due to credit market shifts, the only lender remaining to consider the same retail asset on a long-term fixed-interest-rate basis is a life insurance company. The terms on this loan are much different today: Typically, one will find 65% to 70% LTV, a maximum 25-year amortization, and a spread above the 10-year Treasury yield of 250-plus bps.
How did we get here? The short answer is, the subprime residential mortgage debacle. For years, the government looked the other way as new homeowners, who should have been continuing to rent apartments took advantage of low-interest-rate, no-down-payment teaser loans and seemed to suddenly go brain-dead when they encountered the words "variable-rate mortgage" on the document they signed.
Why shouldn't the government ignore what was going on? Low interest rates and loose credit standards coupled with investors anxious for high yields on risky investments boosted housing prices. What was underestimated, however, was the importance of equity in the motivation of a homeowner to continue to make payments.
There is old adage in lending: "The borrower must have the willingness and ability to make payments." Without those two factors, you have a delinquency on your hands.
Direct impact
The entire subprime debacle was the match that lit the fire and moved rapidly into the commercial mortgage-backed securities (CMBS) market. Although CMBS delinquencies are very low, many of these loans were aggressively underwritten and had long interest-only periods.
Furthermore, the rating agencies did not properly rate the pools in tranching the subordination levels, and investors, anxious for decent yields in a low-interest-rate environment, did not closely scrutinize the pools.
Today, we are in an environment of a complete readjustment of underwriting risk and assigning an appropriate rate. The slumping economy and credit crunch have led lenders to seek shelter during this storm, and the result has been fewer options for borrowers.
Retail properties specifically are in the "caution" category with lenders, along with office properties and hotels. And lenders have good reason to be cautious. The slowdown in the economy, along with the debt-laden consumer, has caused more belt-tightening and less spending.
Retailers' success is dependent upon consumer spending, as well as having the availability of easy bank credit to expand if needed, and neither of these is occurring. There has been a tremendous expansion in retail space during the last 10 years, as retailers opened new outlets to meet the demands of the credit-addicted consumer.
Now, consumers are forced to spend less, and it is uncertain whether spending patterns will ramp up again if the economy improves. High-end retailers are also feeling the pain of a slower economy, with the wealthiest tightening their belts as well.
Retail property types
The cautious lenders consider retail centers (which have enjoyed strong occupancies in the past) with a jaundiced eye, suspecting that vacancies will occur through store closings and lease expirations. Further, because previously strong retail credit is not necessarily regarded as always-strong retail credit, it is unknown how traditionally strong retail companies such as Walgreens and Home Depot will fare in this economy.
It is also not clear where the overall industry is going. Therefore, lenders are naturally cautious in this economy where retail is concerned. The bottom is only obvious in hindsight, and when lenders don't know where the bottom is, they become conservative in their loan underwriting.
Construction loans are more difficult to obtain, more pre-leasing is being required, more equity in deals is needed, and more market scrutiny takes place to assure the viability of a center. Retail properties in secondary and tertiary markets with moderately weak demographics and income levels are difficult to finance over 65% LTV, if at all.
Restaurant properties are not easy to finance but if the lease term is at least 15 years, the strength of the operator is sound and the land value is strong, good loan terms can be obtained.
In the current climate, grocery-anchored retail is still the favorite among lenders. In general, the better the grocery credit and longer the lease, the easier it is to finance and, consequently, receive better loan terms.
For the first time in recent history, lenders are concerned about bank outlots, given the tremendous losses many banks have experienced during the last year. Additionally, unanchored retail centers are difficult to finance unless at least a 10% vacancy (or existing vacancy, whichever is greater) can be used in underwriting, and borrowers will find a maximum 65%-70% LTV.
Regional malls were difficult to finance prior to the capital market changes given the influx of lifestyle centers and their success. Now, the most successful regional malls, of course, are ones within excellent demographic areas and whose developers have re-skinned the malls to make the outside more appealing and accessible to shoppers.
Currently, lifestyle centers can still be financed, but the transactions will usually feature lower LTVs than before – approximately 70%-75%. Lenders will consider potential future vacancies with lease expirations and tenant move-outs. An additional risk with lifestyle centers is co-tenancy clauses that smaller tenants often have with the larger "draw" tenants to the centers.
Overall, what does the future of lending on retail properties hold? It is unlikely that underwriting will be more aggressive than it is now until lenders see signs of stability or improvement. The economy will have to improve and the consumer must begin spending again for retailers to begin to flourish and consider expanding once again.
At the same time, the bright light upon the horizon is that this is an excellent time for borrowers with liquidity to take advantage of purchase and yield opportunities that have not been in the market for years. Also, life insurance companies will continue to lend, probably getting more aggressive on loans as the bottom of the market is apparent.
Conduits will be back certainly with more scrutiny and oversight by rating agencies and when investors gain confidence in the CMBS pools. It is more important for borrowers than ever to consult an experienced mortgage banking professional for guidance in this volatile marketplace.
Susan Branscome is principal and executive vice president of Q10 | Triad Capital Advisors Inc., based in Cincinnati. The firm is an affiliate of Q10 Capital LLC, currently servicing a commercial loan portfolio in excess of $17.86 billion. Branscome can be contacted at (513) 985-4000 or sbranscome@q10triad.com.
