Q: What are your predictions for retail financing going forward? For 2021?
A: The Covid-19 crisis has accelerated the retail transition that futurists have predicted since the rise of the Internet. The Global Pandemic has reshaped the retail and commercial real estate landscape forever. It is not just teens and millennials that have figured out how to shop online. Older and less tech-savvy consumers have embraced technology to order groceries and basic necessities and have them delivered right to their door or have the items picked from the store shelves and ready for contactless pickup. Uber Eats and Doordash deliver restaurant food to your home. Consumers have realized how easy and painless online shopping is and will continue this practice moving forward. The need to get in a vehicle and go to a retail establishment is profoundly different now than before the crisis.
This means that there will be four types of retail in 2021 forward:
- Online retailers like Amazon with a robust infrastructure and ability to make deliveries in hours, the next day or within two days will continue to thrive. Development and financing opportunities will abound for retail showrooms (e.g. Apple, Tesla), warehousing, cold storage, and “last mile” infrastructure.
- Freestanding Single Tenant Net Leased Assets with strong, investment-grade tenants and tough to disintermediate business models will continue to be financeable (e.g. Amazon has not figured out how to deliver gasoline by drone). Restaurants with drive-thrus are seeing strong same-store sales growth.
- Shopping Centers anchored by market-leading grocery stores (Publix, Wegmans, etc.) and/or strong big-box retailers (Walmart, Target, Home Depot) will be financeable.
- Non-Anchored Retail Shopping Centers relying on a mix of mom and pop tenants and sit-down restaurants no longer have the same allure as social gathering places. Best-in-breed assets will be financeable at much lower leverage than pre-crisis and may require recourse to obtain rock-bottom rates. Bottom tier assets and inferior locations will struggle to find financing as lenders “just say no” or “press the pause button” until a cure to the virus is discovered.
Q: What will be the biggest trends/changes in retail lending going forward because of the pandemic?
A: Lenders on top-tier properties with investment-grade tenants with strong balance sheets and strong reasons to survive in a post-Covid world will continue to attract financing as lenders have a “flight to quality” mentality. Leverage will be 5 or 10 points lower from the peak, but it will be available from insurance companies, CMBS lenders, credit unions and banks. Certain property types such as enclosed malls and lower-tier properties with an un-attractive post-Covid tenant mix will struggle to find financing from conventional lenders at any leverage, pricing and recourse level. This past week perennial enclosed mall tenant Gap has announced that they will be closing 350 Gap and Banana Republic stores in malls by 2023 to focus on off-mall locations and their growing sub-brands Old Navy and Athleta. Property owners that can not find financing from conventional institutional lenders will be forced to do deals with debt funds, hard money lenders and Loan-to-Own shops underwriting to a discounted land value.
Q: How will underwriting change for retail loans going forward?
A: We see a barbell shaped market with very high-quality opportunities on one side and challenged opportunities on the other side. There will be many assets with cash flow in place that will not attract debt capital until their valuation is no more than the land value of the property. High-quality sponsors that invest in best-in-class assets in compelling locations in markets with strong job growth that are renting to investment grade necessity tenants will have their choice of non-recourse capital at historically low interest rates. These Sponsors will need to live with leverage that is 5-10 points lower than pre-crisis levels. Lenders are showing an increased interest in learning a Sponsor’s net worth, liquidity, and global cash flow much earlier in the underwriting process. The opposite side of the spectrum (secondary and tertiary markets, low growth markets, weak sponsorship, functionally obsolete properties, oversized boxes, weak tenants) will struggle to find access to capital at any leverage level and at any pricing. Many properties will not recover from the Covid-19 crisis and will be foreclosed and repurposed. We see tremendous opportunities to finance construction for all the re-development that will happen over the next decade.
Q: What type of retail properties will lenders target? (location, type, square footage, occupancy histories, etc.)? How has this changed?
A: As in the previous answer, there will be a continued flight to credit quality and to “necessity retail” (grocery, pharmacies, gas, and home improvement). Lenders are seeking loans from best in class Sponsors that have survived multiple market cycles and have a reputation for mitigating risk.
Q: What specific retail tenants will lenders prefer? What tenants will they shy away from? How has this changed since the pandemic?
A: Lenders target the quality and durability of the cash flow to be monetized. Covid-19 has changed the meaning of quality and durability of cash flow as government edict can now close down a thriving, profitable business to preserve public health. 2020 has seen bankruptcy filings for a variety of tenants that were previously shining stars in the industry. Bankruptcy has hit sit down restaurants (Chuck E. Cheese, Ruby Tuesday, California Pizza Kitchen, Sweet Tomatoes), department stores (JC Penney, Neiman Marcus), home goods stores (Pier 1, Tuesday Morning), and clothing/fashion (True Religion, J. Crew, Lucky Brand). Zombie properties with dead or dying tenants will be repurposed to an alternative, lower density retail use with lots of freestanding buildings and outparcels or scraped and repurposed to residential or medical use.
Q: What will be the typical leverage for retail deals?
A: There have been three distinct phases of CRE financing over the last 15 years:
- Before the Great Recession leverage topped out at 75-80% leverage
- In a post-Great Recession world, senior debt from conventional lenders topped out at 65-70% leverage
- In a post Covid-19 world leverage will max at 55-65% for the highest quality properties with top tier sponsorship. Properties that don’t make the cut will find it very difficult to obtain financing at any leverage point and cost of capital in the short term. Be ready for a basis reset and significant need for equity, not debt with a set payment schedule.
Q: What will be the typical interest rates?
A: For the highest quality properties with necessity-based tenants, senior non-recourse debt from conventional lenders will top out at 55-65% leverage at a cost of capital of similar duration US Treasuries plus a risk premium of 200-300 bp. Since the yield on the 10-year Treasury is 0.75% as of this writing, many lenders are utilizing an artificial Treasury floor of 100-150 bp and a minimum coupon rate of 3.25 to 3.5%. Non-recourse lenders typically offer par pricing so any points paid at closing go to the borrower’s preferred mortgage banker/debt placement advisor. For borrowers willing to sign full recourse, consider loans from banks, credit unions and insurance companies at slightly lower rates and less structure (pre-negotiated trigger events, hard lockboxes, cash flow sweeps, springing recourse, etc). For properties with challenges, leverage will be lower and pricing will start at 8-10% with highly challenged properties requiring equity-type returns of 12+% to get lenders interested.
Q: What will be the typical debt yield for this property type?
A: Higher quality properties will require a debt yield of 8%. We see LTV as the limit on loan proceeds, not debt yield.
Q: The typical DSC?
A: Interest rates are at historically low levels. We are seeing lenders put more weight on Debt Yield and Loan to Value or Loan to Cost since debt service coverage is not constraining loan proceeds as it once did.
Q: What will be the hot markets for retail lending this year? What markets will lenders shy away from?
A: There will be a continued flight to quality and focus on credit quality of the tenant. The best markets are showing strong employment trends and job growth. Florida, Texas, Georgia, Tennessee, Arizona, Colorado, and the Carolinas continue to lead the way in employment and job growth. Areas with high taxes and job losses are much more difficult to attract lender interest. Areas with massive Covid-19 exposure will be put on hold until the situation clarifies.
Q: What will lenders look for from sponsors when underwriting? (certain net worth and liquidity, certain number of properties under their belt)? How has this changed since the pandemic?
A: There are three key phases of underwriting over the last 15 years:
- At the height of the go-go market before the Great Recession the Sponsor needed to be able to fog a mirror and not have been recently released from jail for a financial crime (a joke, but you get the idea that underwriting rules were much looser)
- In a post-Great Recession world, lenders required a net worth of 1x the loan amount and post-closing liquidity of 10-20% of the loan amount.
- In a post Covid-19 world net worth and liquidity requirements will be more stringent. We have recently discussed a loan with a lender that requires net worth that is 3x the loan amount and post-closing liquidity for 12 months of P&I payments. Expect lenders to take a deep dive on a potential borrower’s PFS/Schedule of Real Estate Owned. Lenders are heavily scrutinizing contingent liabilities and drilling down on global cash flow. Sponsors that can not meet these guidelines will either not attract financing, will need to pay higher rates to compensate for the risk, or attract another piece of the capital stack via mezzanine or preferred equity.
Q: What are your predictions for the banks and retail lending? What specific bank lenders will be active in the space?
A: There will be necessity retail and everything else. With non-recourse senior debt tapping out at 55-65% LTV creativity will return to the market as Sponsors look at mezzanine, preferred equity, C-PACE and ground lease bifurcations to bring gap equity into their deals. As to banks, according to Wikipedia there are 5,177 banks in the United States. The key will be to find a local bank in the local market that understands retail real estate.