Retail Traffic

Increasing the Odds in Retail Loan Roulette

Small retail properties support the needs of modern life, from eating to dry cleaning to movie rentals. Shoppers can cash a check, pick up a prescription, get their hair styled or buy flowers at such stores. Indeed, strip malls and freestanding outparcels have become embedded into the landscape as the archetypal backdrop of our daily routine. Although these stores are often ubiquitous and generic by design, they are not equal in the eyes of lenders.

Owners, caught up in the frenzy to lease their properties, often lose sight of how lenders will view their decisions. Keep in mind that lenders require detailed information about lease terms and rates, tenant financials, demographics and a variety of other factors before they agree to mortgage financing. Small retail real estate loans usually total $5 million or less, and borrowers can increase their chances if they know what issues are typically of concern to lenders.

For example, lenders may accept some irregularities in a deal if the owner is an accomplished borrower with a substantial retail portfolio. However, if the landlord has no track record, the lender will put more emphasis on location fundamentals and lease dynamics.

A key piece of information is a demographic study of the location. What are the traffic patterns? What is the income level in the surrounding community? Who is the competition? Does the location have any special features that could hurt or help business? For example, a shopping center might be the only stop between a business park and a residential area, meaning workers will stop by for bread, prescriptions, haircuts or car repairs.

When possible, lenders want to review historical figures on tenant sales per square foot. How does this store perform compared with national, state and regional averages? Lenders recognize that landlords cannot always obtain specific store information, but industry databases can sometimes provide average figures, and sales numbers for nearby shops can be useful. If a grocery store reports annual sales of $700 per square foot, a lender can extrapolate potential sales for a drugstore pad site.

Limited Attention Span

Sales figures are more important when the loan will finance a single-tenant location, because the cash flow is dependent on a sole retailer. But in either case, lenders want reassurance that the property will continue to generate revenue. Those in the business say the walk from the penthouse to the outhouse is shorter than ever, meaning today's hot retail concept is tomorrow's failure. Nothing proves out a location better than actual sales.

The tenant mix is another critical factor in the success of a property, and lenders prefer diversification. Take, for example, a typical shopping center with 30,000 square feet. A mix of six or seven tenants, each of which leases 4,000 square feet to 5,000 square feet, offers some protection if one tenant goes dark. The same center with one 25,000-square-foot tenant and a second tenant with 5,000 square feet is riskier.

Landlords also should understand the difference between their perception of a quality tenant mix, and the lender's perception. For instance, an owner may rent a suite of small retail spaces to individual hair stylists for $24 per square foot. The deal looks good on paper, but how realistic and sustainable are these leases? The lender will question the longevity of the concept, particularly if going rents for retail in that location are considerably lower. If a landlord signs a tenant for above-market value, the lender probably will not give extra credit for that. An owner may think he is sitting on a gold mine, but the lender may view it very differently because he has seen too many golden geese turned into Christmas dinners.

Another issue to consider is the lease expiration date. Lenders don't want all the leases to mature at the same time. If a landlord leases a shopping center to six tenants in the same year, he or she should stagger the dates to reduce the impact of lease maturation on cash flow.

Lease Terms are Important

A related issue applies to single-tenant leases. Lenders will be sensitive to leases that expire within the loan term. Ideally, large rollover events won't be hurt by an inability to refinance the loan at maturity due to the lack of remaining lease term. That said, lenders should be willing to work with experienced borrowers who have strong leasing teams and have proven their ability to manage rollover risk. Furthermore, this risk is often mitigated by the properties locational dynamics as proven by high actual or surrounding retail sales figures.

Landlords sometimes run into trouble when lenders ask for estoppels and subordination non-disturbance agreements (SNDAs), two types of documents that acknowledge the lease. A tenant signs an estoppel that says the lease is valid and states the terms, including rent, length of lease and square footage. The estoppel indicates the landlord is not in violation of the lease agreement.

An SNDA recognizes the priority of the mortgage to the lease and says that the lender will allow the tenant to operate under the terms of the lease. In both cases, some retailers will have their own forms for these documents and the lender may want a very specific form used. Leases should be crafted with strong language to ensure that the tenant is not able to hold the landlord hostage when seeking a mortgage. A landlord may want to craft specific compliance periods and financial penalties into the lease agreement.Unfortunately, with large national tenants this is easier said than done.

It's not a Gamble

The type of loan is another factor to consider when compiling a lease application. Permanent loans with maturity dates usually stretching to 10 years are often non-recourse loans, meaning the borrower, as an individual, is not responsible for the repayment of the loan. If the borrower defaults, the lender can only pursue the property, not the borrower's personal assets. While a number of sins can be forgiven with a recourse loan, the property dynamics take on greater weight with a non-recourse loan. At the end of the day, recourse typically translates into flexibility, and non-recourse into comparative rigidity. That said, roughly $90 billion of non-recourse securitizable term loans were entered into in 2004, so the requirements imposed by permanent, non-recourse lenders could not have been too restrictive. In the end, most prudent property investors share in the same structural concerns as lenders.

The degree of recourse may also temper a lender's perspective on the acceptability of secondary or mezzanine financing. This type of debt structure is often prohibited, because lenders don't want to take loans if they have additional encumbrances. They prefer to see 20 percent to 25 percent more cash flow than what is required to pay the interest on the debt, and other types of financing can eat into that cushion. In addition, lenders want to underwrite the controlling parties and do not want to be put into a position where control can change hands without their consent due to nonpayment on the junior liens.

Small doesn't mean simple. Lenders, like equity investors, have a multitude of concerns. To the extent that these concerns are addressed, the odds of your number coming up on the roulette wheel can be greatly enhanced.

National director of LaSalle Bank Real Estate Capital Markets

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