Store closures by Macy’s, Walmart, Sears and others are all over the news and, with these falling dominoes, what others are at risk? Certainly lenders, owners, investors and other co-located retailers may be… but the fabric of some local communities may also change as a result. Commercial real estate players and CMBS players alike, take note, to ensure that retailers’ falling dominoes don’t nick you.
Envision each store closure as one domino. How many others stand ready in line, just behind it? If and when that domino gets knocked over, what impact could that closure have on the buildings in which they’re located, and on the malls, real estate investment trusts (REITs), commercial mortgage-backed security deals (CMBS) and local real estate markets they touch?
The possible outcomes are not only about risk, however. The fact that the store closures are taking place at the same time as a rising interest-rate environment and increased regulatory scrutiny -- and just as a wave of securitized loans made in 2006-7 are maturing -- opens up risk levels. Surprisingly, this combination of circumstances may also ignite refinancing opportunities for the right investors or lenders with higher risk appetites.
Store closures might make some investors think twice about investing in retail in the first place, whether they are interested in retail as an industry or as a commercial real estate property type. Though it is certainly worth taking stock of the risks in any market sector and specific location, it is also noteworthy that demand for retail space grew rapidly in 2015 while supply remains low, pushing rents higher, CBRE has reported.
Let the dominos fall where they may.
Domino 1: The local market
When Walmart moved to Oriental, North Carolina, about two years ago, the Town’n Country grocery was forced to shut its doors after 44 years -- but at least there was a grocery store and pharmacy in town. As Bloomberg reported last month, now that Walmart is shutting down its Oriental location, residents have to go on a 50-minute round-trip drive to stock the fridge or pick up aspirin. And of course, Walmart workers will now swell the ranks of the unemployed.
If no retailer takes up the challenge, this could push down property prices and repel population growth or drive residents away, given how closely local economies are intertwined with local real estate. However, it could also become an opportunity for other retailers and CRE lenders to become the only player in a now open market.
Domino 2: The shopping center
Unlike the Walmart closure, many of the stores that are closing are part of a mall, at a time when malls across the U.S. are being torn down or otherwise neglected. Owings Mills Mall in Maryland, about 20 miles outside of Baltimore, is one of the latest to go belly-up as retailers weed out under-performing stores and traditional (and often decades-old) enclosed malls close their doors, especially if they are aimed at middle-income populations.
“The risk of failure for a mall increases dramatically once you see anchor closures,” Cedrik Lachance, director of U.S. REIT research for real estate analytics firm Green Street Advisors, has said. The firm predicted in 2014 that 15% of U.S. malls will “fail or be converted into non-retail space within the next 10 years,” according to Business Insider.
A little more than an hour’s drive west of Owings Mills is Valley Mall, a super-regional mall in Hagerstown, Maryland, that serves western Maryland as well as parts of West Virginia and Pennsylvania. Among its anchor stores is one of the 36 Macy’s stores shutting down this year. The 120,000-square-foot department store isn’t the only anchor tenant in the mall, but the others include Sears and J.C. Penney, both of which have also recently announced closings, though not for this location. So what effects might the Macy’s closure have on the mall?
On the one hand, if Macy’s has selected Valley Mall as a location worth pruning, presumably because its sales were not burning up the cash register there, then it is possible that other retailers looking to shutter stores will make the same calculation -- especially if the number of shoppers declines with the demise of that Macy’s branch. The mall’s net operating income did drop to $7.63 million in 2014, from $8.12 million in 2005.
On the other hand, with its competitor out of the running, perhaps J.C. Penney and some of the other clothing stores in the mall -- including H&M, which Valley Mall owner PREIT has said will open later this year -- will see sales rise in the same location. Only time, and quarterly reports, will tell.
Domino 3: The REIT
Many U.S. malls, including Maryland’s Valley and Owings Mills malls, are owned by real estate investment trusts.
Valley Mall, which was built in 1974 and renovated in 1995, is owned by PREIT, a Philadelphia-based real estate investment trust that specializes in shopping malls on the East Coast, many of them in Pennsylvania. As of September 30, Valley Mall's sales per square foot were $397 and its total occupancy rate was over 95%, PREIT announced. Though its share price has gone up by 14% over the past five years, it has taken a 29.6% dive over the past year alone.
PREIT expects to earn up to $225 million by mid-2017 by selling off its lower-earning and non-core properties, the Philadelphia-based mall operator reportedly said in an investor presentation in January. These include four malls in Pennsylvania, Alabama and Virginia, Philly.com reported.
Owings Mills Mall is owned by the REIT Kimco, whose shares took a 2% dip over the past year but rose 41.65% over the past five years. The mall closed in September (with some businesses remaining open nonetheless), but Kimco appears to be viewing this seeming loss as an opportunity. After a buyout made Kimco the sole owner of the 1 million-square-foot property, Kimco said in a statement that, while formal redevelopment plans have not been finalized, it is considering “several open-air shopping center concepts.”
These open-air centers, like Santana Row in San Jose, California, and Market Common Clarendon in Arlington, Virginia are often called lifestyle centers, which the International Council of Shopping Centers defines as “upscale national-chain specialty stores with dining and entertainment in an outdoor setting.” They are built in an effort often promoted as creating a sense of community by bringing back the old Main Street. These newer lifestyle centers have been rising in popularity over the traditional enclosed malls built decades ago, growing from 9% of the industry share in 2008 to 15% in 2014, Nielsen reported.
But ABC News noted that if Owings Mills were to become an open-air mall, it would face competition from two new outdoor shopping developments within walking distance.
Domino 4: The CMBS deal
Public investors and capital markets are exposed to CMBS bond risk, too. The Valley Mall in Hagerstown is the top loan in a JP Morgan-issued CMBS deal as of Dec. 31, after several other loans have been paid off. Of the loans remaining in the deal, more than a third are retail properties, some of which have defaulted while the rest are maturing shortly.
All told, there are five delinquent loans in the deal, four of which are for retail properties, and an additional three delinquent loans. However, none of the defaulting or delinquent loans are among the top few loans in the deal.
If multiple loans in a CMBS deal default, those who suffer are typically the investors, especially the lowest tranche of investors.
Domino 5: The lender/originator
Not only is the public investor exposed; there are other risks borne by lenders and the financial system and, clearly, underwriting standards matter. Consider the originator for the $90 million Valley Mall loan, which is coming due in March: the New York branch of a financial institution known at the time as Eurohypo AG (now the German-based Hypothekenbank Frankfurt AG).
Eurohypo was also the originator behind a defaulting $9 million loan in the same 2006 CMBS deal, for a 60,000-square-foot retail strip in North Attleboro, Mass., called Brooks Plaza. That loan was issued on Dec. 16, 2005, and was relatively risky, coming in at a loan-to-value ratio of 79.6%, according to CrediFi data. Earlier this year it was transferred to special servicing for maturity default.
Due diligence and underwriting standards of banks matter even more now, as regulatory change places more risk on the bank. The credit risk retention rule, which comes into effect later this year for commercial asset-backed securities, requires sponsors to keep some “skin in the game,” meaning they must hold at least a 5% interest in the credit risk of a CMBS issuance, in an effort to compel them to be accountable for all their deals. This makes due diligence, risk mitigation and solid underwriting more important than ever.
When stores stay open, we often take them for granted. But when they shut down, they create a domino effect that has an impact not just on the business that closed some branches but on the local market, shopping centers, REITs, CMBS deals and lenders.
