Shaking the tree for shopping center financing

In an unexpected turn from a year ago, now's the time for investment financing of retail properties.

Money may not grow on trees, but for retail property investors, right now it may as well. Rarely if ever, say commentators, has investment financing been so widely available at such attractive terms. For construction financing, the leaves are on higher branches, but developers with sound footing can readily reach them. Those on shakier foundations, however, will either have to piggyback on someone stronger or go without.

"The bottom line is, I think everything's being done in this market," sums up Steve Schmidt, senior vice president/manager of credit tenant properties for Heller Real Estate Financial Services in Chicago, who reports his firm has been doing both equity and permanent financing for everything from freestanding, single-tenant properties to power centers.

According to Martin T. Lanigan, senior vice president of structured finance and securitization for GMAC Commercial Mortgage Corp. in Horsham, Penn., his firm has been covering pretty much the same territory. "We've been lending on both anchored and unanchored, power all the way down through single-tenant retail of high quality," he says, adding that GMAC is even willing to do factory outlet deals.

Several segments of the market -- enclosed malls, power centers and outlet centers -- are experiencing some resistance from lenders, but most respondents indicate properties with good locations and sound tenants have little trouble securing attractive deals.

What is most striking about the current scenario is how different the picture is from only a year ago. The 1997 forecast from Palo Alto, Calif.-based Marcus & Millichap Real Estate Investment Co. termed retail the only sector "not on a measurable track of recovery." In a similar vein, Atlanta-based Equitable Real Estate Investment Management Inc. put a red flag on retail REITs, warning the sector's funds from operations could be hard hit in the upcoming period.

Indeed, lenders appeared to some extent to have adopted this negative view early in the year, but as 1997 wore on, the mood became much more relaxed. By midsummer, retail's star was clearly on the rise.

"It's changed in just the last four or five months," says Schmidt. "For example, we're seeing a return of life companies to retail, whereas eight months ago they were pretty standoffish."

Two factors account for the change in attitude, according to Harry Hedison, director of the Investment Banking Group at Boston Financial in Boston. To begin with, he says, consumer sales are on the rise, with early reports indicating the Christmas shopping season would show much better results than it has for several years. (Later reports suggested sales would not rise as high as anticipated, which may have an impact not foreseen by those interviewed for this article.) On top of that, other categories of real estate investment are falling out of favor due to increased construction and consequent rising vacancies.

"There has not been that much capital flowing into retail in the past few years because of fears there was going to be overbuilding, so construction has been at a minimum," says Hedison.

A third factor, according to Neil Freeman, president of Aries Capital in Chicago, are today's low interest rates. "Interest rates are near historic lows. Anytime you can finance real estate under 8%, there's going to be a lot of demand for financing," he says.

Low rates, he points out, work to everyone's advantage. Although lenders end up playing on smaller margins, the larger volume of loans compensates. In addition, because the borrowers have lower costs, fewer end up unable to pay loans off.

In Schmidt's opinion, the change in attitude is overdue. "What I find fascinating is there's been so much negativity in retail. People say there's too much retail being built, but they weren't focusing on what's being built. I don't see a lot being built that's highly speculative. Most of it is being built because there are tenants," he says.

The apparent excess of supply, he continues, consists largely of obsolete space that needs to be bulldozed and replaced with structures that fit contemporary retailing needs, or with other uses entirely. He says much of the space being built in fact involves redevelopment of existing centers and thus adds little to the inventory of retail space overall.

Statistics actually bear out his favorable opinion of the health of the retail sector, adds Schmidt. "The last time I looked, retail had second lowest default rate. Only industrial was lower," he remarks.

Nonetheless, as Robert Schneiderman, executive vice president of Parallel Capital Corp. in New York, points out, retail is always susceptible to a downturn because it's consumer driven. "The health of the economy dictates how retail does. The economy seems strong right now, but we all know how quickly that can change," he says.

Regional malls face bifurcation As noted above, malls in general have been losing luster. The decline in the number of small shop tenants, the increasing desire of many retailers for freestanding buildings, whether alone or in a power center, the threat from mega centers, and the revival of Main Street and downtown shopping have all combined to weaken the position of formerly thriving regionals.

That said, not all malls have fallen from favor.

"We've seen a bifurcation in the market place, especially vis a vis regional malls," says Hedison. "In regard to Class-A, there's a good solid market for those. With all others, lenders have been very cautious. If they do a loan on a Class-B, they're going to do it in a more conservative manner."

A sizable number of outdated malls remain in operation. Because many of these have long-standing mortgages with low payments, and occasionally have no mortgage outstanding at all, they can operate with high vacancy levels and second- and third-tier retailers. Only when the owners attempt to sell them does it become apparent lenders will not back the properties.

Lenders' reluctance to take on B and C properties has its upside, however. As Hedison points out, the fact that financing is harder to come by has held down values, which in turn has created opportunities for repositioning and redeveloping underperforming centers. The targets, though, are more often the top malls in secondary markets than secondary malls in top markets, he says.

Bernard Freibaum, executive vice president and chief operations officer for General Growth Properties Inc. in Chicago, says his company likes second-place malls because they have greater potential for income growth.

"Single mall owners aren't always aware of what can be done to improve performance," he notes. "We can buy a mall from a local owner and just by applying our management skills, we can dramatically improve cash flow."

In Freibaum's opinion, individual owners are at a disadvantage when it comes to financing.

"For the individual mall owner, nothing much has changed. If you're building a new center, the owner gets as much preleasing as possible and goes to a commercial bank, though some life companies offer a combination construction/mini-perm loan with a three- to five-year term. The amount of equity required is going to be 40% to 50%," he says.

In regard to permanent financing, Freibaum continues, the individual owner can usually get a long-term, nonrecourse loan from a life insurer or pension fund with 60% to 75% LTV. "That's the classic kind of financing that's been around forever," he says.

A REIT or institutional owner, on the other hand, has access to many more sources of capital. Freibaum points out that General Growth has a $200 million line of credit it can dip into at any time. It also has the money it raises on Wall Street, which is used primarily for equity but can be applied to construction as well, and it can borrow on existing properties to raise money for acquisition or construction of others. In November, GeneralGrowth issued its first commercial mortgage backed securities package, which included a bundling of 13 of its malls. The $560 million raised, which Freibaum says will come mostly from institutional investors, will also be available for acquisition and construction.

The players in the mall-lending field, according to respondents, remain life insurance companies, pension funds and REITs, with conduits beginning to show some interest.

Power centers hinge on tenants For power centers, loan deals hang on the reliability of the major tenants, or more accurately the perceived reliability. This sector's retailers continue to experience consolidation and bankruptcy, though not to the same extent they were a couple years ago.

According to John Christiensen, a senior vice president of Fleet National Bank in Boston, Fleet has made numerous power center construction loans in the last couple years, as well as larger community centers and malls. The key with power centers, he says, is to have a significant amount of equity and preleasing. Sponsorship is also critical. "We want to be sure we're dealing with experienced entities, on both the developer and the tenant side," he says. "We also want a comfortable level of recourse."

Christiensen considers online shopping the biggest threat to power centers in the long run. Because power center retailers specialize in brand-name mass merchandise, consumers do not necessarily need to see and touch their purchases before committing to them. Consequently, they could as readily make the purchases from a distance. Although the threat is not imminent, Christiensen says he can see it becoming a reality during the life of loans with terms of 15 years or longer.

Few players dominate outlet centers Outlet centers have largely become the domain of a few major players. Their records all but guarantee continued funding. Smaller outlet centers or outlet centers by smaller developers do get built and financed, however.

Andrew S. Oliver, managing director of Sonnenblick-Goldman in New York reports his company is working on finding financing for a $65 million outlet center. "We have a lot of interest. It's just a matter of different structures..."

Although Fleet has not funded any outlet centers, Christiensen says the bank is not averse to them. "I think they're viable, and many of them prove it. The stereotypical concern has been the shorter lease terms. Outlet tenants traditionally wanted only three- to five-year leases, which made lenders uneasy. But now that they see their outlets are viable profit centers, manufacturers are willing to sign longer leases," he says.

Entertainment & Specialty Centers A year ago, lenders approached entertainment centers with extreme caution. Too few had long enough records to properly evaluate their viability. The number of entertainment centers has exploded over the last 12 months, and the verdict is definitely in their favor. A clear indication of this is the $177 million Credit Suisse, through First Boston, is providing Cleveland's Forest City Enterprises for a massive project intended as a cornerstone for the redevelopment of Times Square in New York.

Oliver reports that Sonnenblick-Goldman found financing for a $60 million project in the Kip's Bay area of Manhattan to be anchored by a large Sony multiplex theater and a Barnes & Noble bookstore.

Large specialty centers have a much longer record and the market has embraced them with little regret. Oliver says a $110 million refinancing of Pier 39 in San Francisco, expected to close in December, came through quickly and without a hitch. The only delays were on the part of the borrower, who wanted to be sure of getting the best deal.

Many entertainment and specialty centers, especially in big cities, receive public help with financing through access to low-priced bonds, low-interest loans from city coffers or direct subsidy. Often the city or other governmental entity will participate as an equity partner.

Neighborhood/Community Centers Neighborhood and community centers with supermarket anchors have supplanted regional malls as the No. 1 investment category, according to most respondents, and lenders tend to be very aggressive in pursuing them.

Gregory J. Spevok, vice president and director of originations for Bear, Stearns & Co. in New York, calls them the "bread and butter" of his company's retail lending business. A significant aspect of their attraction, he says, is their location on generally prime sites that have high built-in land value. The other major factor is that they provide goods necessary for daily living and consequently are less subject to economic downturns.

David Sonnenblick, a partner in Sonnenblick-Goldman, reports a $33.4 million first mortgage arranged for Potrero Center, a 226,646 sq. ft., Safeway-anchored center in San Francisco, came through quickly and easily, with a number of lenders competing. First Union of Charlotte, N.C., took home the prize.

The center is in many ways typical of today's supermarket-anchored properties. In the past, most supermarket projects consisted of grocery store, drug store and other small shops for day-to-day needs such as drycleaner, pizza parlor, card shop, bank branch and video store, with perhaps one or two fast-food operators on pads. While such centers still get built, more common are projects that share characteristics with power centers. Potrero Center's tenant roster, for example, includes Old Navy, Ross Dress for Less, Super Crown Books and a fitness center.

The reason for the change of format, according to Lisa Weitzman, director or Hidalgo & Co. in New York, lies in the fact that drug store chains have been gravitating to freestanding sites and contemporary supermarket chains build stores of 60,000 sq. ft. and up that include some of the services formerly provided by small shop operators. Centers with traditional 20,000 to 30,000 sq. ft. supermarkets are among the most difficult to finance unless the site can accommodate a larger, modern store, she says. Otherwise, lenders recognize the operator very likely will close the store down and open a new one elsewhere, leaving the property with no anchor and little chance of finding a replacement with equivalent draw.

Single-tenant Single-tenant net lease developments have become one of the most popular retail real estate investment categories. The attractions are obvious: a single credit tenant with known record and a guaranteed long-term lease.

Charles Corson, director of the Retail Investment Group of Staubach Retail Services in Dallas, reports his company's Wolverine Equities division purchased $400 million in single-tenant retail properties from January through November of 1997. The total included $138 million for Rite-Aid stores and $85 million for Circuit City stores.

According to Gary Ralston, president of Commercial Net Lease Realty Inc., Orlando, Fla., his company does nothing but these single-tenant transactions. "We're essentially an equity REIT. We have 45 retailers in our portfolio and a target list of 100 retailers," he says.

In regard to how CNL works, Ralston details, "When a developer has a site under control and a signed letter of intent with a tenant, we turn on the turbo chargers. provide equity and help him finish the lease, which he can take that into a bank to get a construction loan." His firm also does sale-leaseback transactions, in which CNL buys the land and leases it to a credit tenant, which then builds its own store. In both cases, CNL makes a forward commitment to provide takeout financing when the building is complete and the tenant has moved in.

Paul McDowell, vice president and general counsel for Capital Lease Funding Corp. in New York, says his company specializes in sale-leasebacks. "We are able to finance a property by relying on the credit of the tenant. The result is we're a discounted cash flow lender. We can give borrowers very high debt service cover," he remarks.

Unanchored no longer taboo Not too long ago, to utter the word unanchored within hearing distance of a lender meant kissing chances of funding goodbye. Today, a surprising number of lenders will gladly consider them, though usually at higher spreads.

Raymond Au, a vice president in the San Francisco office of New York-based ORIX USA Corp., says his company actually prefers unanchored centers to anchored ones. "We shy away from credit-tenant anchored centers because of the low pricing offered by the conduits. We can't match that. We need higher spreads," he explains.

The trick with unanchored centers, according to Schneiderman, is take extreme care in choosing a location.

"What we're looking for are locations that are convenient and where you have the ability to cut off traffic. We want it to be hard for people to go somewhere else," he says. "We also look closely at demographics. Are there significant numbers of people living or working a short distance away?"

For Au, a site adjacent or across the street from a large anchored center is ideal.

Occupancy history is another critical factor of the project itself, if possible, or of the surrounding neighborhood if the project is new, adds Schneiderman. "You're likely to have more turnover in an unanchored center. What we want to know is whether stores in the area as well as the project remain vacant for long periods or whether they quickly find new tenants. You're evaluating the submarket pretty heavily to see how strong it is," he explains.

Also examined, he continues, is how the cost of occupancy and sales per square foot compare to similar businesses at both the local and national levels. The experience of individual tenants also counts. If a store is the third unit for a local mom-and-pop retailer or if a tenant has been operating for 20 years, that counts in a project's favor. New independents with solid business plans and substantial capital also look good, he says.

Stanley Seid, an assistant vice president at United Savings Bank in San Francisco, says a project's track record is the most important criterion in lending on an unanchored property. For a new center, the developer's track record is the key. "We don't look just at the collateral of the property itself but also the business skills of the management and tenants," he says.

Typical of the unanchored centers that Parallel funds would be a four- or five-unit strip on an urban shopping street or a six-unit residential building with ground-floor retail in a dense urban neighborhood, according to Schneiderman, who says Parallel makes loans from as low as $150,000 all the way up to $25 million.

"There's opportunity across the board in the lower-end segment," he comments. "Primarily, the only class of lender to service that market is a network of local community banks. We're an exception, and I believe we offer a better product. The difference is that we process quicker and offer a long-term fixed rate, up to 25 years. Most banks will offer only up to five years."

ORIX, however, confines itself to the $2 million to $12 million range, with the average deal coming in between $5 million and $7 million, according to Au. "Most of our borrowers are not mom-and-pop investors. They're medium-sized, seasoned real estate investors," he says.

Lenders go to battle on terms As indicated above, interest rates are about as low as they have been in many a moon. Lenders compete on spreads, making rates even more attractive than they would ordinarily be. They also go to battle on terms, amortization schedules and loan-to-value ratios. As Au of ORIX puts it, "We can structure a deal 10 ways to Sunday."

"We do coverages as low as 120 (over 10 year Treasury bonds) with a 30-year amortization on strong-anchored retail deals. That's how confident we are," says Bear Stearns' Spevok in regard to permanent financing. Based on mid-December rates, a 120 spread would translate to an interest rate of barely 7%.

Parallel also writes down to a 120 spread over Treasuries, according to Schneiderman, while Hedison reports Boston Financial has done deals with only 80 point spreads. "These are for A quality malls where the borrower has 50% equity," he explains.

B and C properties are not likely to get nearly such good terms. Freeman says Aries may go as high as 8% for the riskiest projects. Staubach's Corson says he has heard of loans with 350-point spreads for extreme high-risk projects. The companies doing such high-risk deals did not exist a few years ago, he remarks. "There are probably 50 of them today. They're riding the wave of real estate appreciation," he says.

In regard to LTV ratios, Schneiderman says Parallel may go as high as 80%, though 75% is more typical. According to Freeman, Aries will often go to 85% or 90% on loan to value. "With credit tenants, you can go almost to 100%, providing there is demonstrated cash flow to support it," he says.

There seems to be less variation among lenders regarding length of loans. Most report the average is 10 years with 25- or 30-year amortizations, but Oliver says seven-, eight- and nine-year terms are not unusual at Sonnenblick-Goldman.

Respondents indicate the majority of loans are fixed-rate, though some borrowers prefer floating, according to Jim Howard, managing director of TransAtlantic Capital Co. in New York. "Some borrowers come with property [on which] they anticipate increasing revenues. Others want to sell in a couple of years, or they're accumulating because they want to become a REIT. They want short-term loans, and to get those they're going to have to go with a floating rate," he explains.

Spevok says Bear Stearns offers earn-out financing for some of those types of situations. "We can increase the amount of initial funding six to nine months down the line in response to an enhanced income stream, usually due to the signing of a new tenant. We do a lot of those," he says.

For construction loans, terms are not so generous. Anxious to discourage overbuilding, lenders make the barriers to new development a little higher. Nonetheless, from a historic perspective, these rates are still quite attractive. Christiensen pegs spreads at 150 to 200 points over LIBOR for new construction, somewhat less for expansions and rehabs. Redevelopment might fall into either category, depending on the particulars, he says.

How long the current climate will last is anybody's guess. Although respondents see some signs of overbuilding, most respondents believe the retail market is reasonably stable. The following statement from Oliver expresses the common view.

"The next year or two look good. There's still some shakeout and bankruptcies, and you have to be careful in the mall market. Otherwise I'm optimistic," he says.

What some people forget, he says, is that shopping centers have lagged behind other product types in regard to recovery because they were last to go down. "If you look back five years, no one would touch hotels or office buildings" he adds. "Suddenly they boomed, and now there's so much building going on investors are backing away. With shopping centers, values have not climbed much, which is why people are willing to lend -- values are not inflated. That makes them very attractive to investors. They realize values will rise."

Christiensen agrees: "There's no question there's an enormous amount of capital available. We see significant pressure on loan pricing but have not seen a deterioration in credit structures. While there's a lot getting done, hopefully there's no drop in underwriting standards and we don't have to worry too much about another crash."

In Au's opinion, investors in retail real estate may never have it so good again. "It's a competitive market for the loan industry," he says. "We have to do whatever we can do to get the deal in."

John McCloud is a San Francisco-based writer who contributes frequently to Shopping Center World.

Not too long ago, developers and owners had to compete for the few loans that were available. Lenders dictated the terms and conditions. Today, it's lenders competing with each other to convince the borrower to take their money.

The $21 million permanent loan TransAtlantic Capital Co., the U.S. conduit for Germany's Deutsche Bank, provided the owners of Fruitvale Station Shopping Center in Oakland, Calif., makes agood example.

Fruitvale Station is a 163,195 sq. ft., 16-tenant center on an infill site in a lower-income neighborhood. Although the average income level is not high, the population numbers are, and residents have few shopping options. A shortage of other developable sites nearby makes it unlikely competing centers can get built.

According to Roy G. Norwood Jr., senior vice president and managing director of Grubb & Ellis Mortgage Group Inc. in Dallas, 65% of the tenants are investment grade and 84% have leases of 10 years or longer.

Norwood and G&EMG vice president Charles R. Babb Jr. had an exclusive contract to market the project. "Normally, we would have gone to the top five or six lenders who do this type of project, but because of the nature of our engagement, we were forced to turn over every rock. We wound up getting almost 30 proposals," says Norwood.

The offers covered a wide range of options. Spreads varied by as much 65 basis points (over 10-year Treasury bills) and loan amounts varied by up to $5 million.

To land the deal, Jim Howard, TransAtlantic's managing director, relates that the firm had to offer a higher loan-to-value ratio and a lower spread than it typically gives. This loan had an 80% LTV. The fixed 7.37% interest rate represented a spread of 145 basis points over 10-year Treasury bonds.

"It was a very attractive property from our perspective," says Howard. "We felt very comfortable taking an aggressive position."

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