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Game of Loans

January 21, 2020 | By John Cumbelich

In a fast-changing retail landscape in which retailers of all shapes and sizes — big box stores, department stores, and other retail brands — are regularly shuttering due to the shift to e-commerce, lenders will increasingly find themselves in the uncomfortable position of owning retail real estate that was underwritten in the pre e-commerce paradigm.

In order to fund their original loan, a lender’s underwriters determined that these assets met the institution’s conservative requirements. That meant, in part, that if the loan failed to perform, the bank would find itself with an under-leveraged and fundamentally sound asset on its books. But some 9,300 store closings in 2019 alone, the most ever, are putting that claim to the test. According to Coresight Research, closures jumped an astounding 60% from the 5,844 the firm tracked in 2018. This is some of the most under-reported and unsettling news in a national economy which keeps grabbing headlines for a roaring bull market and low unemployment.

Worried? Consider this: UBS reports that another 75,000 stores may be lost by 2026, as online shopping continues to expand. Rest assured that lenders are paying attention to these trends. While the impacts on employees, shoppers, landlords, and communities will all be painful, perhaps the audience that will be hardest hit are the lenders that risked the capital investment into the real estate that these brands have abandoned.

So what will this mean for the rest of us? Here are a few observations.

  1. As traditional retail continues to struggle vs. e-commerce, lenders will deemphasize retail real estate in their portfolios. Some may abandon retail altogether. This disciplined approach will likely translate to higher underwriting standards and more challenging loan terms.
  2. Like many investors, lenders will likely focus on more conservative retail investments, such as single tenant net leased properties occupied by credit tenants.
  3. Look for lenders on retail real estate to put more pressure on borrowers, thus limiting the risk on the lender, with more recourse requirements. This pressure will inevitably slow down transaction volume in the retail space.
  4. When loan terms and loan-to-value requirements become more conservative as lenders look to offset the risks associated with e-commerce, we forecast the rise of non-institutional mezzanine debt. This more expensive source of financing will seek to bridge the shortfall between a borrower’s capital needs and his primary lenders maximum loan exposure. But more expensive mezzanine debt will raise the hurdle on the return needed for a borrower to achieve positive leverage in a given investment, further slowing down transaction volume, and adding to upward pressure on CAP rates.

The early 2000’s were known as the dot-com era. While this chapter in the national economy is remembered derisively as a posterchild of boom & bust, characterized by too many investors rushing into a fledgling industry before it had learned how to properly execute on its lofty business plan assertions, clearly the seeds of today’s e-commerce bounty had been successfully planted.

With e-commerce having hit its stride today, a new paradigm in retail real estate is being created in real time. Lenders, investors, retailers and other market participants must make fundamental changes to adapt to this new paradigm.  While surging e-commerce makes the case for slowing traditional retail real estate development and investment, lenders will likely respond with increasingly conservative loan requirements.  The current low-interest rate environment has effectively masked the impacts that growing e-commerce is having on retail real estate lending. When interest rates move higher over time to more historically normal levels, the limitations of traditional lenders will become far more apparent.

But just as these still nascent market conditions will dampen private investor activity, a simultaneous opening will occur for buyers that don’t need to rely on lending institutions, such as REITs, users and investors with access to public markets, hedge funds and other institutional investors. Indeed, they may benefit if CAP rates rise while traditional lenders de-emphasize or exit retail.

And here you have the Game of Loans.