Fortunately, predictions of a retail apocalypse have not come true. But investors in this sector have to be extra creative to get their deals financed. It’s not about where your project is located— the core of every real estate venture—it’s about how you will enliven that center so it can keep up and succeed in the experiential retail era.
Continental Partners President Mitch Paskover shares his insights into the complex and subtle process of retail financing and analyzes the risks and challenges in the segment.
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What are the biggest challenges in the retail financing landscape?
Paskover: A lack of availability of high-quality core assets on the market, coupled with slowdown of new construction, means that retail investors looking for new opportunities in the sector will often need to strategically retenant and rebrand—and in some cases completely renovate and reposition—older centers.
As a result, sponsors will require loans with rates and payment schedules that accommodate a deficiency of in-place cashflow, and in some cases, large-scale renovations. This can involve more time and negotiation, and the need to cast a wider net for potential lenders in order to secure competitive financing. For example, we recently secured financing for the acquisition of a shopping center with a drug store and grocery anchor in Reno, Nev. We approached nearly 30 lenders in order to secure a loan with a balance of strong loan-to-cost and competitive leverage with interest-only payments for four years to satisfy the sponsor’s requirements.
What can you tell us about the price of capital for retail investments?
Paskover: Lenders will continue to price risk into loans, so we will likely see leverage continue to lower slightly overall. We have experienced lenders hesitant to go above 60-65 percent loan-to-cost, especially for loans with an interest-only component. That said, we anticipate that a 70-75 percent ratio will remain achievable, as long as debt coverage ratio and debt yield covenant is met.
Retail loans are typically being priced in the high-4s to low-5s range, dependent on the strength of submarket and property fundamentals, as well as leverage—the lower the leverage, the more competitive the rate. Typical debt yield will be most competitive in the 8 to 9 percent range, with debt service coverage at 1.3x or better.
How have the needs of retail borrowers changed in the last few years? What do you expect going forward?
Paskover: With the continued growth of e-commerce and other trends impacting consumer habits—as well as the high competition for core assets and well-located properties that offer prime value-add repositioning opportunities—sponsors must be creative when approaching real estate investments. This includes having a plan in place to procure a highly varied and strategic tenant mix, or if applicable, to complete a conversion to an entertainment-based or mixed-use center.
Sponsors can best navigate the current climate and prolonged process to secure competitive financing—with the terms to accommodate these plans—through identifying a finance partner who is well-versed in strategically demonstrating asset value and communicating investment strategies to potential lenders.
Tell us about the particularities of underwriting for rehab vs. conversion of retail properties in today’s late cycle landscape.
Paskover: CMBS loans can be a strong option for investors looking to obtain higher-leverage loans with relatively low interest rates for the acquisition and minor upgrades of older, yet well-located, retail assets. At Continental Partners, we often structure mezzanine behind CMBS in order to secure higher loan amounts for retail assets.
However, if a sponsor is planning to perform significant renovations or convert a retail asset, CMBS loans do not tend to offer the flexibility to facilitate these. We typically recommend bank loans for those projects.
Competition is growing in the financing sector due to the significant influx of capital. How is this manifesting in the retail segment?
Paskover: While looking at the sector as a whole indicates that retail’s performance pales in comparison to other product type,s such as multifamily and industrial, the right assets and execution are still presenting tremendous value. Debt reserves are high and offer the potential to create value in retail assets that either have exceptional historical performance or strong retenanting plans and projections.
Investors and lenders alike are becoming more and more sensitive to shifts in consumer preferences and habits. While lenders are pricing loans accordingly, we are not typically seeing them completely exit the retail property lending space. Due to the plethora of capital sources available to access, even sponsors pursuing retail investments considered riskier still have attractive options—it just might take some extended time and effort to secure them.
The CMBS delinquency rate in the retail space has seen the largest year-over-year drop—33 basis points to 4.29 percent, as of May, according to a Trepp report—among other property segments. Why do you think this is? What does this tell us about the retail segment?
Paskover: We’ve seen steady drops in CMBS delinquency rates across most product types over the past several months—this overall trend is due primarily to the fact that more troubled legacy loans have been resolved and issuances have remained steady.
Retail CMBS loans continued to see higher delinquency rates following major closings of large retailers in recent years. This significant drop in delinquency is likely a testament to more strategic investment and conversion of vacant retail spaces in recent years, and more conservative underwriting of CMBS loans.
What do lenders need to know about risks in today’s market?
Paskover: After years of “the demise of retail,” dominating industry conversations, the market is fairly steady and owners and retailers are, in general, well-tuned to evolving consumer habits after some hiccups over the years.
That said, all lenders should remain very diligent in their analysis and underwriting. Within the fickle retail sector, a sponsor could have an excellent vision to reposition a center within a city with the right demographics and demand drivers—and that center could still fail for simply being a few intersections away from the heart of the town, thus not offering peak convenience to a large portion of residents or because of similar tenant mix competing a few miles away.
What are your predictions on the evolution of capital markets in the years ahead?
Paskover: In addition to carefully evaluating anchor tenants and tenant mixes to ensure stability of retail centers, lenders will look to comprehensive demographic studies to determine future potential. For strong value-add opportunities, lenders will continue to take a critical eye to repositioning strategies and submarket fundamentals, underwriting lower leverage loans to mitigate risks.
With the rollback of some of the provisions of Dodd-Frank last year and continued improvements in the overall health of the economy, we also expect that smaller lenders will continue to enter, or reenter, the space and be more willing to consider higher-risk loans, including those financing retail and other product types, which could create more options for sponsors.