2009: Riding the cycle

By Randall Shearin
Shopping Center Business - March 2009
2009 is seeing the retail real estate industry go through massive changes. Where are we headed? How will we get better? Where are the opportunities? Over the last month, SCB spoke with brokers, bankers, and owners, and studied many research reports and trends to develop this article. Ever heard the old adage that you have to get worse to get better again? That may be the case for the retail property market in 2009. There are a number of factors at play that are going to change the face of the shopping center industry over the next year.

Shaky financing, shrinking value, little capital in the market, tenant failures, a consumer base that isn’t spending and an undefined government bailout are just a few of the topics that are at the top of every mind in the industry. And, as with any situation, there are opportunities for savvy companies who know how to play the market.

No Credit

The first problem that the industry is facing is that few banks are lending on sizeable loans. The commercial mortgage backed securities (CMBS) market effectively shut down during the summer of 2008, cutting off all but a trickle of lending to the industry. In 2007, $230 billion in CMBS loans were underwritten; in 2008, that number dropped to $12.1 billion, according to research provided by the Commercial Mortgage Securities Association.

Even properties with conventional financing aren’t untouchable in this environment. A number of owners have defaulted because of poor performance of the centers. The center may not be fully leased up, or it may have lost tenants, impacting net operating income. This, in turn, affects the owner’s ability to make its loan payments. For properties purchased during the recent boom — when cap rates were low — any variation from the norm and it’s easy to upset the apple cart.

“Many properties with loans written from 2003 to 2007 are underwater,” says Bernard Haddigan, senior vice president and managing director of Marcus & Millichap’s retail group. “You have a situation where rents are softening and expenses are increasing. Owners often have no choice but to default on their loans.”

If your financing is in place you may think you’re ok, but what if your loan is coming due in 2009? After all, according to JP Morgan, an estimated $20 billion worth of CMBS loans are maturing this year, followed by $30 billion in 2010. In fact, over the next 4 years, $140 billion in CMBS will be coming due. How do you refinance a loan of $10 million or more in 2009 when no bank will give you credit? If you’re not overleveraged, there may be hope, but this isn’t the case for every owner.

“There are a lot of loans on watch at this point,” says Greg Maloney, head of Jones Lang LaSalle’s retail group. “A lot of the loans are performing loans, but they may be up for refinancing. Some of them are short-term loans or floating-rate loans. In a lot of cases, the availability of capital to refinance is the biggest issue.”
Already, 2009 has seen a few retail properties fall into receivership or be taken back by lenders. In St. Petersburg, Florida, Wells Fargo foreclosed on BayWalk, an entertainment center owned by a local developer. In New York, The Shops at
Atlas Park — promoted as the first lifestyle center in Queens when it opened in 2006
— was recently taken over by two French banks that held a $128 million mortgage on the property.

Part of the problem with refinancing a loan in 2009 is equity. Property values are falling, destroying equity that an owner has in a center. According to recent research by Jones Lang LaSalle, for many properties purchased since 2005, owners’ equity has almost evaporated. A developer owning such a property financed at an 85 percent loan-to-value ratio with an interest-only or low interest loan — as many were in 2005 — now has negative equity. That is, the loan balance is more than likely greater than the current value of the center. Many loans have strict covenants on them. These include provisions that state how much equity the owner must have invested at the property at any given time. Keeping this loan current or refinancing it in 2009 is going to require quite an equity commitment from the borrower: you will have to lay equity into a sinking asset in order for the loan-to-value ratio to hit the bank’s desired numbers. Again, that’s ok if you are willing to ride out the storm and take the gamble that, in the long term, the center will be worth more after the economy improves. But do you want to put more money into a sinking ship? It is a tough spot — the owner is faced with two options: pay down the loan to the bank’s numbers using equity in order to refinance (if it can get a loan) or hand over the center and walk away.

The second choice is the hardest pill for anyone to swallow. While owners with a few toxic loans may be able to negotiate new loans for properties based on equity from other assets in their portfolios, a developer trying to pull this off on multiple loans will be forced to turn a few back to the bank. Some may be forced into bankruptcy.

“This is really an unprecedented situation due to the CMBS debt structures,” says Haddigan. “Really, this is the first cycle we’re going through with all this conduit debt out there.”
On top of this, according to Haddigan, retail properties in many markets may not see appreciation for 7 to 10 years.

“There is a lot of stress in the system right now because a lot of properties’ occupancy has decreased,” says Maloney. “We also know that the value of these assets have dropped. There is a big spread between the seller’s asking price and what a buyer is willing to pay.”

A Wave of Property

Several times in 2008, Shopping Center Business heard from sources, “The only centers that are on the market are properties that have to be sold.” In other words, most of the centers hitting the market last year had owners who were in trouble and had to sell the asset for various reasons. Beginning in a few months, according to Haddigan, a number of pre- and post-foreclosure properties of all sizes will begin to hit the market.

Jones Lang LaSalle currently has 15 retail properties that the company is operating under receivership status. Receivership generally occurs when a borrower defaults on the loan and the lender requests the court to appoint a receiver for the asset. The receiver operates the property on behalf of the court while the lender and the borrower are negotiating a settlement or workout.

“Retail is the leading edge in receivership,” says Maloney, who conservatively estimates that the company will operate two to three times the number of retail properties under receivership by the end of 2009. “Receivership is really a good option when the value of the property has fallen well below the loan amount.”
Jones Lang LaSalle applies many of its talents to the properties it holds in receivership. For instance, if a loan workout is required, the company will call upon its investment banking group to step in.

Take backs will lead to the second way the industry will change: properties could flood the market. As in good times, the best assets will be the first to be snapped up. After all, there are many solid shopping center owners with plenty of equity and little debt who have been waiting for the wave to crash. There are also private equity funds that have money and are just waiting for prices to fall.

Many of these investors have been patiently waiting for high-flying companies who gambled on low-cost, short-term capital to crash. They have identified the assets they want; now they are just waiting for them to become available at rock bottom prices. If the owner puts them on the market before the bank takes them, they won’t see any interest from buyers. Investors just want the properties; not the higher price that comes with them now. After the lender insists upon a solution from the current owner, it will come to market at a reduced price. All the lender wants is a fair share of its loan value back. At some point, as more and more properties hit the market and compress prices, the bank will be willing to sell the center for a fraction of its original market value. This, of course, leads to price erosion on healthy properties. Haddigan reports that many banks automatically discount a property’s assessed value by 30 percent, thus reducing its post-take back asking price.

In Southern California, a nearly new home furniture anchored center, South Coast Home Furnishings Center, was sold after the owners defaulted on the loan and the property entered receivership. In that case, Burnham USA picked up the property — which last sold to a group of investors for $100 million shortly after completion in 2007 — for $35 million.

2009 has seen only a few assets like this come to market. But the wave is headed to shore. Predicting a harsh repricing period, Jones Lang LaSalle’s Americas research group also predicts tremendous buying opportunities for well capitalized entities. The group also predicts that certain assets will be coming to market at pricing “unlikely to be seen again for multiple economic cycles.”

What’s holding the wave back right now may ironically be the banks. When a property enters a default period, a commercial real estate professional is often called in by the bank to issue what’s called a “broker’s opinion of value” (BOV) to assess the value of the center. Smart brokers realize that this will soon lead to the bank filing a notice of default (NOD) on the loan. In some markets, the number of BOVs that brokers are issuing is not correlating to the number of NODs, according to Haddigan. This means that the bank is holding on to the loans, creating extensions to the owners, trying to workout a solution with the owner, or trying to figure out what the bank will do with the property.

“In the short run, some lenders are reluctant to file the notice of default,” says Haddigan. “Acknowledgement of the default impacts their balance sheets. Instead, they will try to work out or sell the notes. Now, the broker’s opinions of value are coming back from lenders and special servicers. We would see significantly more default filings, but the banks are holding off. Many lenders simply do not want to take all these properties back right now for a variety of reasons including management capacity, operational risk, liabilities, etc. Ultimately, with all the stresses accumulating in the capital markets, there is no doubt that we will see a significant wave of distressed commercial assets coming to market both in the near term and likely over the next several years.”

Economic Factors

Delinquency and default rates on commercial mortgages are expected to climb through the next 2 years, according to Jones Lang LaSalle. What will cause this? In the retail sector, the economy will be mostly to blame. With consumers spending less, retail bankruptcies and store closings have already become common. Every center has an operating budget, and when net operating income is disrupted by larger than anticipated vacancies, loan delinquency and default may be unavoidable. In the past, owners could extract capital and refinance to keep things going, but with the banks unable to lend, this option is no longer available.

The foreclosed properties themselves could lead to a bigger problem: they could further prevent the bank from being able to lend. After all, banks are not in the real estate business, they are in the lending business. The number of foreclosures will create a larger aspect to one area of our industry: distressed assets.

Many companies active in the investment brokerage sector, like Sperry Van Ness, CB Richard Ellis, Marcus & Millichap, Grubb & Ellis and Jones Lang LaSalle, have begun distressed asset initiatives to work all angles of this part of the real estate cycle. Sperry Van Ness has created its Asset Recovery Team to create a seasoned group of experts in the field [see related article on page 38 of this issue]. The group contains everything from receivers — professionals who are appointed by the court to operate a property while it is in receivership — to those who specialize in extracting capital from real estate assets in order to recapitalize.

Companies like Marcus & Millichap, Jones Lang LaSalle and Sperry Van Ness are being proactive — and smart. They see the wave coming. They are positioning themselves to specialize in working with banks on foreclosed assets. There are many roles to play. Some companies, like TriMont Real Estate Advisors and RADCO Development Solutions, make distressed properties their specialty. RADCO, which specializes in large-scale mixed-use and multifamily developments, will even go as far as taking title to the property. The company earns its fees based on services like completing construction or leasing up the property, or selling units. In the foreclosure process of a retail property, there are many areas for a third-party provider to make money. Someone has to manage the property, someone has to lease it and, eventually, someone has to sell it on the lender’s behalf, just to name a few.

Among the properties Jones Lang LaSalle is operating under receivership is Macon Mall in Macon, Georgia. The center was placed in receivership as the lender became concerned about the borrower’s ability to continue successful operation of the property.

“In 95 percent of the cases, the goal is to sell the asset and distribute any proceeds above the loan amount to the borrower,” says Maloney.

In today’s investment climate, however, lenders are likely to settle for less than the loan value. Part of the problem with a sale today is value. Since few sizeable properties have traded hands over the last year, there are no comparable sales to judge value. Plus, the added pressures the economy has taken away from a property’s value are difficult to judge.

“Lenders are realistic about properties they request be taken under receivership,” says Maloney. “They know a property for sale in today’s market will take some time.”

People Are Shopping

Top centers are still the top centers in the market. If you go to your nearest super-regional mall, you’ll find it looks pretty much the same as it did a year ago. Tour buses — though not as full or as frequent as they may have been a few years ago — are still arriving. Shoppers are still there, and they are still buying — albeit not as much or as frequently.

Consumer behavior has radically changed over the last 18 months. First, gasoline prices hit consumers’ disposable incomes hard. Next, the burgeoning recession struck a panic in many people. Instead of “spend, spend, spend,” the motto nearly overnight became “save, save, save.” Retail sales have been on a general decline since mid-2006, and have fallen sharply after government issued economic stimulus rebate checks were issued during the first and second quarters of 2008.

Why? Housing value boosted consumers’ net worth. It — and the banks — allowed consumers access to capital that was rarely touched before. People could live in a different manner on equity. However, many borrowed the equity in a manner that they couldn’t afford: short-term, low-interest loans. They used the equity to buy other items they could not afford, like automobiles, televisions and furniture. When the first wave of 5-year low-interest adjustable rate mortgages hit their reset period, many figured out they would not be able to afford their mortgage at a higher rate, even if the rate was fixed. The subprime loan crisis was underway. With so many homes on the market — again, most were on the market because they had to be — housing values began plummeting, destroying a lot of net worth and sending a shock wave through the economy. Businesses began to feel the effects, and layoffs ensued. The near failure of the country’s banking system in the fall of 2008 was in part the result of the effect of short-term financings.

Consumers — even those who didn’t borrow cheaply and over indulge — are now shaken. Consumer confidence is at an all time low (the 25.0 figure reported by The Conference Board in February 2009 is the lowest since the statistic began being monitored in 1967).

In several attempts to fix the system, the government has stepped in. In early February, Treasury Secretary Timothy Geithner announced a financial sector recovery plan, which included an “asset purchase plan” to create a public-private entity to purchase toxic assets, including the residential and commercial real estate loans that are burdening banks. The hope in this is that it will take these assets off the banks’ books and free them up to lend. The plan was immediately criticized for being too broad and lacking detail, though further announcements have since firmed up some of the plan’s goals.

Another ray of light recently announced was President Obama’s housing stimulus, designed to help underwater homeowners. While this will be good news for an estimated 3 million homeowners whose value has decreased below their loan amounts, it may not have much of an effect on commercial real estate.

“This may eventually lead to some liquidity into the banking system, which may free up some cash,” says Maloney. “There are critics on both sides saying this will and won’t cause an effect.”

One of the ideas bantering about is the creation of a “bad bank.” This could appear as something along the lines of the Resolution Trust Corporation (RTC). Created as part of the savings and loan bailout in 1989, the RTC was a government-backed corporation that held all the properties guaranteed by loans from the savings and loans. In order to get them off the books, the RTC sold the properties — often for dimes on the dollar — to investors. Many companies in the industry now, such as California-based Westrust, started by buying RTC properties.

There would be a big difference between the RTC and any new vehicle created. The RTC handled a little less than $400 billion in assets during its 6-year lifespan. Any new vehicle would be anticipated to handle a much larger amount of assets. As with the RTC, though, this vehicle would cause a number of new players to develop in the industry, fostering recovery.

Surviving 2009

What will happen when the wave of retail properties eventually hits the market? Values of some properties will be driven down.

“Is it true that the more B malls that are on the market, the less valuable they will be?” says Maloney. “Sure. Buyers will look at the best ones first, which will naturally devalue the others.”

There could also come a time when the banks can no longer hold the real estate assets. Lenders may begin selling them at reduced pricing. Again, the problem with this relates to valuation. Until one lender begins to sell, no one will know the pricing.

“There may come a point in time when the banks say they don’t want to own these assets,” says Maloney. “It’s like jumping off a cliff; nobody wants to go first because you don’t know what’s down there.”
How do companies that aren’t having problems protect themselves? Owners will have to watch operating costs, vacancies and other performance related areas carefully [see also “2009: What’s A Developer To Do?” on page 46 of this issue].

“If you own a property and your loan is performing, and you don’t have to refinance, there may be some struggle,” says Maloney. “You should try to maintain your net operating income in 2009 and hope to show some growth in 2010. Properties who maintain their NOI in 2009 will be fine. Properties who lose big boxes and department stores will be problematic.”

Another positive note, says Maloney, is that retailers generally want to expand.

“We don’t give retailers a lot of credit and we should,” he says. “They foresaw the [economic] problems about a year ago and they bought merchandise accordingly. All of the downward [sales] that you saw by the retailers in the fourth quarter of 2008 were anticipated by the retailers. They bought less inventory because they knew they were going to sell less. It was a self-fulfilling prophecy that sales were down.”

The number of retail bankruptcies has been less than predicted, says Maloney. Retailers who did declare bankruptcy, like Circuit City, threw up a lot of red flags in the fourth quarter of 2008 to make the probability of their demise known.

“For the most part, we haven’t seen the mass retail bankruptcies that were predicted,” says Maloney. “Retailers are healthier than we anticipated.”

While some experts say now is the time for retailers to renegotiate rents in centers, Maloney says this should only be done in cases where the store is at risk.

“Developers and owners are going to look at the same fundamentals they have for years,” he says. “They are going to look at what the tenant is able to pay and if the retailer is doing everything possible to make sure the store is operating properly. If I look at the occupancy costs and I see that the retailer is doing everything it possibly can, and we need them in the center, we will take a look at the deal. If the retailer is threatening to close a store when their occupancy costs are inline or below what is acceptable, we are not going ”

Most REITs, who have their own set of issues, have already retooled their businesses. Many have shut down their development divisions and focused on operating their existing portfolios. In this economy, though, when forced with financial expectations, some REITs may be forced to sell properties to raise capital.

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