By Ann Hambly
The success of a mall depends on the performance of the many different retailers in that mall — especially the anchor tenant. The owner of any mall that has a JC Penney, a Sears or some of the large Furniture Brand stores is probably keenly aware of some of the latest news:
- JC Penney Co. Inc. has been in trouble for some time with decreasing revenues and higher than expected losses.
- Fitch has downgraded JC Penney, including downgrading the issuer default ratings to junk status.
- Sears Holdings Corp. is bleeding substantial cash each quarter and has declining store sales. Mired in years of declining sales, Sears has closed 68 of its stores since 2009 and 125 of its Kmart stores.
- Furniture Brands International, which makes Thomasville, Broyhill, Land and Drexel Heritage, filed for Chapter 11 bankruptcy protection in September 2013.
The reason retail is so dependent on an anchor tenant is that many leases on smaller spaces contain a “co-tenancy clause” that gives that retailer the right to a rental reduction if key tenants or a certain number of tenants leave the space.
When a JC Penney or Sears is forced to close a store, owners of the mall end up losing a lot of revenue because the remaining tenants demand rent reduction. The loss of an anchor tenant causes a loss of traffic to the mall, which has the net effect of causing the other tenants to suffer.
There are currently more than 100 CMBS loans backed by shopping centers where Sears and JC Penney are two of the top three tenants. Think of the impact both store closures in one of those locations would have on a mall.
Worse Than Meets the Eye
Given the news that we have all heard about major retailers, you would expect to see a large delinquency rate for CMBS loans secured by retail properties. Yet, as of August 2013, the CMBS loans secured by retail properties posted the second lowest default rate of all property types, or 6.2 percent, according to Chicago-based investment research firm Morningstar.
Source: MorningStar
In fact, for the first 10 months of 2013, the retail sector has posted a lower default rate than all other major property types with the exception of multifamily.
Now let’s look forward. The leading predictor of future defaults is the number of loans on the watchlist. As of September 2013, retail accounted for more than 25 percent of the total Morningstar Watchlist. The only property type that is in worse shape is office, which accounted for 36 percent of the entire CMBS reported watchlist.
Source: MorningStar
The main reasons cited for the retail loans appearing on the watchlist were:
- a significant decrease in the cash flow since loan origination
- a significant drop in occupancy
- a pending loss of a major tenant
- a bankruptcy of a major tenant
According to Morningstar’s Monthly CMBS Delinquency Report for September 2013, the bulk of the loans added to the watchlist in September 2013 alone were from the retail sector.
Also, Morningstar states that retail collateral by far has the greatest risk exposure on the watchlist by loan count. It is safe to conclude that 2014 should see a rise in defaults on CMBS loans secured by retail.
It is important to note that loans with upcoming maturity risk are typically only placed on the watchlist 12 months or less from the maturity date, so it is safe to assume that the majority of the upcoming maturity risk in 2015, 2016 and 2017 is not reflected in these watchlist figures.
Many leading industry experts believe that a large majority of CMBS loans (including those backed by retail) will not be refinanced because the existing loan is overleveraged. Add to that the fact that many retail loans have anchor tenants with leases that expire within a year of the maturity date.
That poses many significant challenges for retail owners in situations where it is not clear today how they will pay off their existing CMBS loan.
Case Study
To demonstrate the challenge, let’s recap a current real-life situation on a CMBS retail loan:
- The property is currently leveraged at approximately 90 percent loan-to-value.
- The asset is fully performing and cash flow is sufficient to pay the loan as structured.
- The current loan matures in late 2015.
- A new loan will likely not be higher than 75 percent loan-to-value, therefore the owner will need to fund the additional 15 percent in order to pay off the current loan.
- The anchor tenant’s lease expires in early 2015, six months prior to the maturity date.
- The anchor tenant is requiring significant improvements to its space to renew its lease in addition to a lower rent payment so that it is more in line with the current market.
In this scenario, the anchor tenant needs to decide whether it will stay in the current space or find a new location within 18 or more months from its lease expiration.
Meanwhile, the owner would gladly invest the capital required to retain the tenant, but will need an extension on the loan term to ensure that it has the funds to refinance. The owner should approach its lender and discuss the situation and everything should be worked out, right?
Well, let’s now assume this loan was in a CMBS pool. We all know that the only party that can grant an extension on the loan is the special servicer. Hopefully by now it is clear that there are only two ways to get to the special servicer: (1) an actual default; or (2) an imminent default, neither of which are present in the above scenario.
The most obvious solution is to request an extension on the loan. The problem is that there is no way to get to the special servicer, and the master servicer can usually not grant an extension of one to two years.
So, what is an owner supposed to do when faced with this stressful situation? Remember that this is a situation where the loan is performing, the anchor tenant is still in place and the existing loan is not overleveraged. Unfortunately, there doesn’t seem to be any easy answers.
Here are some solutions to consider:
- Have the anchor tenant renew its lease without any lease term changes or any tenant improvements. That’s not likely to happen.
- Have the owner agree to fund all capital requirements of the renewing tenant even if it doesn’t know how it will be able to ever pay off the loan. Again, that’s not likely.
- Have the new lender make a commitment for the takeout financing with the uncertainty of the anchor tenant lease. Once again, that’s not likely.
Obviously none of these solutions is very appealing.
The only real way to solve this issue is to realize that it is in everyone’s best interest for the anchor tenant to stay in place. The problem is that every party is looking to the other party to solve the problem.
- The anchor tenant will not renew its lease as is with no tenant improvements.
- The owner will not agree to fund all capital requirements of the renewing tenant without knowing that it will be able to pay off the existing loan at maturity.
- The new lender will not make a commitment for the takeout financing without the certainty of the anchor tenant lease.
- The current lender cannot grant an extension of the existing loan until the loan is transferred to special servicing, which can’t be done until right before the expiration of the lease.
The CMBS industry needs to focus on this issue soon before tenants decide to go shopping at another mall.
Ann Hambly is the founder and co-CEO of 1st Service Solutions, a borrower advocacy firm based in Grapevine, Texas. To date, 1st Service Solutions has advocated over $11.5 billion of CMBS loans on behalf of borrowers and has over $4 billion in process.