Q: What are your predictions for retail financing going forward?
A: The Coronavirus / Covid-19 crisis has reshaped the retail and commercial real estate landscape forever. The less tech savvy in our society have embraced technology to buy groceries and basic necessities and have them delivered right to their door. They have realized how easy and painless it is and will continue this practice to some extent once the crisis is in the past. The need to go to a store is profoundly different now than before the crisis.
This means that there will be four types of retail going 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 store), warehousing, cold storage and “last mile” infrastructure.
- 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).
- 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 restaurants no longer have the same allure as social gathering places. The best in breed assets will be financeable at much lower leverage than pre-crisis and may require recourse. Bottom tier assets and locations will struggle to find financing as lenders “just say no” or “press the pause button” until the situation clarifies.
Q: What do you think will be retail lenders' response to the current market? What will be their plans going forward?
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 may be 5 or 10 points lower, but it will be available. Lower tier properties will struggle to find financing. Lenders that were extremely active pre-Covid are flatly turning down opportunities or “pressing the pause button”. Lenders that are pressing pause will want to see rent collections for April and May before sharing a soft quote, term sheet, or loan application. Leverage will be 10-20 leverage points lower.
Q: What will be the biggest trends/changes in retail loans going forward versus what we have seen in the past?
A: The Internet and Artificial Intelligence delivering goods to your front door have automatically changed the game. Covid-19 has accelerated the use of shopping technology on smartphones, iPads, and computers for those that previously never shopped online. Online shopping is not a fad, the trend will continue. When potential illness or death is on the line by gathering in groups, how do we motivate people to travel to a retail location and spend money? Necessity retail (grocery, drug, and home improvement stores) will continue to anchor shopping centers that lenders will want to finance.
The rise of Internet shopping over the last decade has pushed developers to create shopping centers that are an “experience” that online retailers can not duplicate (IMAX movie theaters, rock climbing walls, indoor ski slopes, hipster restaurants, etc.). The Covid-19 crisis means these experiential retail properties that create social gathering places with tenants like gyms, restaurants, bars, coffee shops, and food halls are now closed and will be closed in many markets for the foreseeable future. Once the health crisis is over, will customers be resilient and come back to these tenants with their hard earned dollars? Or are they going to stay home, order a meal from Grubhub, and watch Netflix? Some lenders will view Covid-19 as a temporary impairment to value. Others will view the coronavirus crisis as a complete destruction of value for certain retail properties. Many of these properties are going to default on their debt. There will be opportunities to acquire these assets at a significant discount to replacement cost and be re-developed.
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 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. 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? (class, location, size, occupancy histories)? Why?
A: As in the previous answer, there will be a continued flight to quality. Lenders are seeking best in class sponsors that can mitigate the lender’s risk by contributing substantial equity. Lenders are showing increased interest in green projects that save on resources, electricity, and water boosting NOI and the corresponding value of the property.
Q: What specific retail tenants will lenders target? What tenants will they shy away from?
A: Lenders target 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.
Q: What will be the typical leverage for retail deals?
A: There are three key phases of 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? Points?
A: Senior 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 250-300 bp. Since the yield on the 10 year Treasury is 0.75% as of this writing, lenders are utilizing a Treasury floor of 75-150 bp and a minimum coupon rate of 3.5 to 4%. Non-recourse lenders typically offer par pricing so any points paid at closing go to the borrower’s preferred mortgage banker/debt placement advisor.
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.
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. Texas, Florida, Georgia, Tennessee, Arizona 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, liquidity, number of other properties, etc.)
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. They will heavily scrutinize contingent liabilities and 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 mezz or pref equity.
Q: What specific lenders will be the most active in retail financing this year? (specific names please, we don’t direct quote)
A: The usual suspects: Goldman Sachs, Wells Fargo, JP Morgan, Morgan Stanley, Citigroup, UBS, Merrill Lynch/Bank of America, Deutsche Bank for permanent financing. Non-Bank Lenders and Unleveraged Debt funds for heavy repositioning and construction lending.