Retail-backed CMBS loans continue to draw mixed reviews from lenders and investors. Where some see a ticking time bomb, others see an opportunity to invest in high-quality, conservatively underwritten retail loans.
There is no question that both lenders and investors are wary of the risks associated with retail. “Unless a property is really, really top notch and performing extremely well, it is a struggle to get financing,” says Manus Clancy, senior managing director and the leader of applied data, research, and pricing with Trepp. Property owners continue to lose tenants through bankruptcies or store closings, with examples across all segments of the industry, notably department stores, big-box stores and grocery stores, he adds.
Regional malls have taken the brunt of the impact. Although it has been difficult for many owners to backfill the large anchor spaces, better performing properties in strong markets have been dealing with small shop closures that are less impactful. “I don’t think the retail landscape is dire,” says Jen Ripper, an investment specialist at Penn Mutual Asset Management. “We are still in this favorable economic backdrop, which is supportive of broader commercial real estate fundamentals in general. So, delinquencies have been coming down a bit and there are stable occupancies and rent growth.”
However, there is clearly diminished appetite and an overall trend to limit retail exposure in new CMBS. Data from Commercial Mortgage Alert, an industry newsletter, shows a decline in retail-backed CMBS issuance in recent years. Issuance was more heavily weighted in retail in 2012 and 2013 at 39.4 percent and 31.7 percent of total annual volume respectively, as compared to annual retail issuance that accounted for 20.8 percent of total issuance volume from 2014 to 2019. Year-to-date retail issuance for 2019 is at 15.1 percent or $6.5 billion of the total $43.0 billion in issuance.
Those retail loans that do make it to CMBS issuance these days have to be really “bulletproof,” with high quality assets, great tenants and high sales per sq. ft., along with more conservative underwriting, notes Clancy.
Delinquency data points to continued woes in the retail sector. Retail is leading other property types in troubled loans. Rating firm Moody’s is reporting a delinquency rate of 5.5 percent for retail vs. 3.5 percent for commercial real estate overall. Trepp also lists retail as the worst performing sector, with delinquencies at 4.44 percent compared to 2.84 percent overall.
The one-two punch for retail is that delinquencies are a little higher, and the success rate of recovering from a delinquency is much lower as compared to other property types, says Eli Gamboa, director, structured products analysis & trading, at SLC Management (formerly Sun Life Investment Management). The firm invests in assets across fixed-income products and real estate equity and debt, including investment-grade CMBS.
Yet investors do recognize that retail is a bifurcated market. They are wary of those assets that are weak or mediocre, with capital still available for better quality assets. Broadly speaking, new retail issuance being done is focused on high-quality assets and more conservative underwriting in terms of lower leverage and good debt service coverage. “In the market overall, retail is getting a lot more scrutiny from all investors,” says Geoff Caan, managing director, U.S. public credit, at global asset management firm SLC Management.
SLC Management is comfortable investing in CMBS issuance with retail exposure to high quality assets and conservative underwriting. Gamboa also points out that other property types have potential issues. For example, hospitality tends to be a very cyclical business, while suburban office can also be very bifurcated, he says. “From our perspective, we think the market is paying a lot of attention to retail risk and not as much to other sectors,” he says. “It has to be retail we like, but we are comfortable buying deals that have higher concentrations of retail.”
Tracking 2.0 loan risks
There has already been some heavy lifting to clean up bad legacy 1.0 loans that were done pre-recession. “The losses were plentiful, and that story has been largely written,” says Clancy. The story that is still playing out is in CMBS 2.0, which includes high concentrations of retail loans originated from 2012 to 2015. “That is a little bit worrisome, because people were still giving retailers a fair amount of proceeds for malls and retail properties and not anticipating how dramatic the impact from e-commerce would be,” he says. “So, those remain ground zero for people’s concerns.”
Although industry insiders might anticipate problems ahead, it is still early stages on deals that were done largely with 10-year terms, which puts the leading edge of maturities out at 2021 and 2022. Some anticipate problems ahead due to problematic vacancies and declining debt service coverage ratios. “It is a problem that some people expect to get worse, but the rubber hasn’t hit the road yet,” says Clancy. The most recent Trepp data for CMBS 2.0 shows that retail delinquency rate is at a slight 1.07 percent, which is ahead of lodging-backed loans at 1.7 percent and multifamily-backed loans at 1.62 percent.
Ratings agencies are also keeping a close eye on some mall loans from earlier 2.0 deals. For example, Fitch Ratings has put a negative outlook on some tranches in deals containing certain 2.0 mall loans that have declined in performance. Even if the mall is currently performing, Fitch has said that there are significant questions regarding whether there will be any financing available at loan maturity.
Waiting to see when or if that other shoe drops does have some investors lining up their bets on the long and short side of existing CMBS tranches. Some investors have been taking sizable short positions on CBMS 2.0, while those that think retail owners can manage through challenges are on the opposite side. “I think there is smart money on either side of that bet, and only time will tell,” says Clancy.