Q: What are your predictions for retail financing going forward? For 2020?
A: Amazon and online retailers have changed the game forever. I can’t recall a conversation with a lender when they did not weave “Amazon effect” into the conversation. Every retailer is reviewed on their ability to withstand competition from online retailers. Retailers that were investment grade a decade ago have vanished. Lenders will continue to fund projects occupied by the highest quality retailers that can’t easily be disintermediated by the Internet. Food, fun, and social gathering places have displaced retailers that don’t have a reason to exist in the physical world. With 2020 being an election year, look for investors to book as many loans as possible before Memorial Day.
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 automatically have changed the game. What can be done to motivate people to travel to your location and spend money? Necessity retail (grocery and drug stores) will continue to anchor shopping centers that lenders will want to finance. Lenders that turned up their noses at restaurant tenants suddenly love restaurants because they attract shoppers and create an “experience” that online retailers have not figured out a way to duplicate. Millennials seek social gathering places (so they can be in a crowd of people staring at their phones and not talking to anyone around them) like gyms, restaurants, coffee shops, and food halls.
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. The opposite side of the spectrum (secondary and tertiary markets, low growth markets, weak sponsorship, functionally obsolete properties, oversized boxes) will struggle to find access to low-cost, non-recourse capital and will need to settle for lower leverage and full recourse. 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.
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. Tenants in industries such as groceries, pharmacies, restaurants are predicted to thrive. Tenants with business models prone to Internet disintermediation will not attract capital. Tenants that lenders previously snubbed such as restaurants, gyms, and family activity centers (trampoline parks, arcades, bowling, etc.) are now seen as magnets to draw activity to a retail center.
Q: What will be the typical leverage for retail deals?
A: In a post Great Recession world senior debt from conventional lenders tops out at 65-70% leverage. This new normal is compared and contrasted to 75-80% leverage a decade ago. Investors/Developers that seek higher leverage need to seek out alternative sources of capital and be willing to pay a higher interest rate and origination fees. We are seeing significant interest in capital stacks involving mezzanine, preferred equity, and C-PACE to add additional leverage to fill this funding gap.
Q: What will be the typical interest rates? Points?
A: Senior debt from conventional lenders tops out at 65-70% leverage at a cost of capital of similar duration US Treasuries plus a risk premium of 175-250 bp. Based on the 10Y Treasury Yield of 1.85% as of this writing, this pegs the interest rate at 3.60 to 4.35% fixed for a 10 year term. Depending on the quality of the asset and the results of the property condition assessment, the payments can be amortized over 20, 25, or 30 years. In certain cases interest only is possible for one or two years. If leverage is less than 60% full term I/O can be negotiated. 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: For higher quality properties debt yield of 7.5 to 8% is standard. As the quality of the property, market, sponsorship dips the DY will be greater than 9%.
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. The best markets are showing strong employment trends and job growth. Texas, Florida, Georgia, Tennessee, 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.
Q: What will lenders look for from sponsors when underwriting? (certain net worth, liquidity, number of other properties, etc.)
A: The rule of thumb is that Sponsors need to have a net worth of 1x the loan amount and post-closing liquidity of 10-20% of the loan amount. So there is no ambiguity, if we are requesting a $20 million loan, the Sponsor will need to have a NW of $20 million with $2 to $4 million in post-closing liquidity. 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 industrial financing this year? (specific names please, we don’t direct quote)
A: The usual suspects: JP Morgan, Merrill Lynch/Bank of America, Deutsche Bank for permanent financing. Non-Bank Lenders and Debt funds for heavy repositioning and construction lending.
Q: What are your predictions for adaptive re-use retail projects? More or less going forward? What tenants do lenders prefer?
A: Adaptive re-use will continue, but sometimes the best way to adaptively re-use real estate is with a bulldozer and a clean sheet of paper. Functionally obsolete buildings can’t be fixed with a fresh coat of paint. Some big box retailers are just too big, some buildings have ceilings that are too low or bathrooms that are too small to meet ADA guidelines. These buildings will be demolished to make way for something new and fresh.
Q: What are your predictions for the economy in general as we go into 2020?
A: Lenders fear frothy real estate valuations and will continue to de-lever investment real estate. A decade ago high leverage from a senior lender was 75-80% LTV/LTC. Now high leverage, senior permanent tops out at 65-70% leverage on retail properties. I believe this will be reset again to 60-65% leverage as lenders become very active in managing their basis. Sponsors will need to become more savvy in bringing multiple tranches of mezzanine, preferred equity, C-PACE, and joint venture equity capital into their deals. Recent rate cuts by the Fed are a sign that the economy is slowing and that the economy needed to be stimulated.