Will CMBS Lenders and Borrowers Adapt to the Shifting Retail Landscape?
Over the past two years, quarterly earnings results that followed holiday shopping seasons have come with a side of fresh store closures as well as new bankruptcy filings by major retailers. In the first few weeks of 2017 alone, long-established chains such as RadioShack, JCPenney, Macy’s, CVS, and Gordmans announced plans to shutter hundreds of underperforming store locations from their portfolios, putting added pressure on numerous commercial real estate landlords and mall center operators.
The trend reflects the ongoing effort of retailers to reduce costs and focus on new showrooming and omnichannel strategies that better cater to the purchasing tendencies of today’s consumers, a sizable portion of which includes millennials. The confluence of e-commerce, changing consumer shopping habits, and new technological enhancements has shifted the retail landscape away from traditional uses of large physical footprints and the one-dimensional approach to sales as discount, experiential, and specialty retailers continue to rise in popularity.
The national delinquency rate (categorized as 30 or more days past due, in foreclosure, REO, or non-performing balloons) for loans securitized into private-label CMBS deals has been steadily increasing during the “wall of maturities” period, as the large wave of more than $300 billion in legacy loans issued from 2005 to 2007 inched closer to their scheduled maturity dates. Many of these seasoned, 10-year loans that came due did not pay off or refinance in time, pushing up the CMBS delinquency rate across all property sectors. Loans backed by retail properties currently possess the second-highest rate among all major property types, behind office loans. The retail delinquency rate has been fluctuating near the 6 percent-mark since last October and clocked in at 5.92 percent for the month of February, roughly 70 basis points higher than the level from 12 months ago.
From a historical perspective, however, retail delinquencies recovered more quickly than other major property types after the financial crisis. Special servicers acted more swiftly to foreclose on distressed retail collateral to cut losses, in contrast to the “extend and pretend” approach more commonly employed with other property types. While the retail delinquency rate has largely trended below the overall rate during the recovery, mounting retail defaults have caused percentages to climb above the national average CMBS delinquency rate across all property types over the past two years.
At the moment, the 20 largest CMBS loans secured by distressed retail make up about 25 percent of the total balance for all delinquent retail loans. Major loans that have fallen past maturity in the past year include several that are backed by shopping centers formerly owned by the Westfield Corporation that were later sold to other REITs: the $240 million Westfield Centro Portfolio, the $140 million Westfield Chesterfield, and the $110 million Westfield Shoppingtown Independence note. Of particular concern from this list is the Westfield Centro Portfolio loan. Thus far, the loan has tacked on an appraisal reduction amount (ARA) of $166 million as well as $26 million in advanced appraisal subordination entitlement reduction (ASER) and fees. The ARA is an estimate of anticipated losses that may loom ahead based on a property’s appraised value and the amount that is projected to be recoverable at liquidation, while ASERs are used to determine the payments that servicers should be advancing on a loan. This could ultimately lead to very heavy losses for the JPMCC 2006-LDP7 transaction, a deal which also houses a number of other defaulted retail and office loans.
Another Brick in the Wall of Maturities
Thanks to historically low interest rates, an abundance of available capital, and the large maturing volume, more than $245 billion in private-label securitized mortgages have been paid off or refinanced since the start of the “wall of maturities” in 2015. As the two most dominant property types in commercial real estate lending, retail liquidations amounted to over $70 billion, or approximately 29 percent of this total, while office made up another 31 percent. The six-month moving average loss rate for retail loans has been trending downwards since mid-2016 to the 46 to 48 percent range in recent months. The loss severity is a percentage calculated by measuring the amount of realized losses associated with a loan against the unpaid principal balance at disposition. (As an example, the loss severity for a $100 million loan that was closed out with a $10 million loss is 10 percent). During this time frame, 9.59 percent of all retail loans were written off with some kind of loss at an average loss severity of 48.06 percent. By comparison, 13.13 percent of office loans have taken a loss, generating an average loss rate of 43.20 percent.
The current status of maturing loans can serve as an indicator for losses and refinancing outlook. Based on a February snapshot, around $102.2 billion in fixed-income mortgages are still up for refinancing this year, with retail loans making up around 29.81 percent of this number. The maturing volume falls to $86.4 billion combined between 2018 and 2021, but retail loans will comprise large portions of each yearly maturing total after next year. Looking at retail loans that will come due for the remainder of the year, 26.57 percent is in special servicing while 25.08 percent is 30 days or more delinquent on payment. 10.37 percent of the maturing balance through December has been assigned $3.2 billion in total ARAs, a good chunk of which will show up as losses taken by the borrower. The average occupancy level for this batch of properties is currently pegged at 93.4 percent. Rising NOIs, persistent low interest rates, and solid commercial real estate fundamentals will enable many of these loans to pay off in the next few months while others obtain additional financing.
Since risk retention rules that place higher capital charges on issuers were implemented in late December, CMBS issuance has dropped off considerably from previous years. Issuance reached $11 billion in the first quarter of 2017, which is a 34 percent decrease from the same period in 2016. In particular, growing angst surrounding widespread retail downsizing has caused some pullback as the share of retail loans in the issuance pipeline dwindled to 15.27 percent in the first three months of this year, down from 26.12 percent and 24.93 percent of total volume for 2015 and 2016, respectively. Looking at the favorable pricing garnered by risk retention deals issued thus far, issuance may pick up as regulatory uneasiness recedes in the coming months.
X Marks the Spot: Retail Exposure in CMBX
Earlier this year, the CMBX market was put in the spotlight after Bloomberg reported that analysts at Deutsche Bank and Morgan Stanley saw an opportunity in betting against portions of CMBX 6 and 7. CMBX comprises a series of indices referencing 25 fixed-rate CMBS that are used by traders to gauge the creditworthiness of the current securitized mortgage market. The two CMBX series, each derived by a group of conduit transactions from the 2012 to 2013 vintages, are thought to bear greater exposure to struggling U.S. malls and shopping centers than the more recent 8 to 10 indexes. Bankruptcies and closures by large department anchors may cause other tenants at malls with lower traffic to leave, which in turn would trigger extensive retail defaults in the underlying securities.
The recommendation has been to buy default protection on BBB- paper, bonds that are a step above junk. Based on Trepp’s internal database, just over $9.6 billion in CMBS loans across 47 deals are tied to shopping malls behind the CMBX 6 and 7 series. These loans appear to carry a benign profile — the notes have a weighted average loan-to-value rate (LTV) of 61.29 percent and debt service coverage ratio (DSCR) of 2.20x, while weighted average occupancy stands at 94.07 percent. All of the loans remain current on payments while a small subset of them (5.35 percent of the balance) are on the servicer watchlist. Perceived risk in these series have caused a recent blowout in subordinate, BB and BBB- spreads at the bottom of the credit stack. The sell-off has spilled over to sub credit spreads in the cash market and the more recent CMBX counterparts that feature more conservative underwriting and less exposure to low-quality malls. Ultimately, this raises concerns about whether the assets are becoming vastly undervalued. As current market mispricings return to more normal levels and retail participants work to stay relevant in the changing consumer environment, CMBX investors may be able to weather this so-called retail storm.
The E-commerce Impact
According to the U.S. Census Bureau, online retail sales only made up 8.3 percent of total sales volume in the fourth quarter of 2016 on a seasonally adjusted basis, which suggests that online retail is only one factor causing the decline in traditional brick-and-mortar establishments. The ability to see and test merchandise in person stands as the core component of the overall retail experience, and physical retail will continue to be in demand, albeit with slightly different concepts and leasing arrangements. Landlords and tenants are largely attuned to prevailing retail trends, while REITs have been re-purposing lower-producing Class B/C malls to include more integrated technologies with greater drawing power. While many department chains will boast smaller footprints in the coming years or may leave the brick-and-mortar sector altogether, those that successfully adapt to the shift in the way retail spaces are modeled and utilized will be the ones that remain and thrive.
In terms of the retail sector in the CMBS space, formidable obstacles stemming from new regulatory headwinds and election year uncertainty have already caused noticeable changes in the securitized lending realm. Coupled with stabilizing property values and upcoming interest rate hikes, many borrowers will find it increasingly more difficult to secure new loans. On a positive note, the market has proven to be resilient and is holding up very well in light of all these changes, and potential deregulatory policies favored by the new administration could provide some welcome relief to the industry.
— Catherine Liu
Catherine Liu is a research analyst with Trepp, which provides data, analytics, and technology solutions to the global securities and investment management industries.