Chief Strategy Officer, CenterState Ban

Introduced in 1937 in an Oklahoma Humpty Dumpty supermarket, the shopping cart has proven to increase per person sales and extend shopping time. A boost to many retail establishments, it is often said to be a predictor of retail health. More shopping cart sales equals more store openings. The problem is that sales are slowing. This is germane to banks as commercial real estate exposure related to retail property financing composes an estimated 22% of community bank commercial real estate (to also include mixed use). The problem is that after hitting a low in probability of default back in 2013, risk is on an upswing. As traditional physical stores such as Sears, Macy’s, JC Penney’s, Wet Seal, Barnes & Noble, Abercrombie, American Apparel, Radio Shack, Aeropostale and others struggle, traffic at many retail locations are significantly off. This is occurring at major malls and for smaller community centers. The result is more risk for banks that are lending. Today, we quantify the risk and discuss mitigates that banks can take.

Why Risk Is Increasing

It is no surprise that online retail purchases are increasing and now makes up 7.5% of all retail sales, up an average of 15% year-over-year (see US Census Bureau chart below). This macro change means that retailers have too many stores. In addition to this permanent change, there is another potential transient change in demographic composition in that more Millennials are relocating to cities and staying there longer. This has shifted the economics away from the suburban shopping channels. In addition, young Americans are often finding large box retailers off-putting and seek more boutique stores and non-chains in order to achieve more uniqueness. 

As the economy healed by 2012, retailers resumed their square footage expansion despite flattening traffic and sales. Now, the industry is paying the price. Too much supply and lower demand is causing a right-sizing and banks that are not paying attention could get caught in the middle.

Tenant Analysis – Through The Looking Glass

Like Alice In Wonderland, things are not what they seem when it comes to tenant risk. The script has flipped and traditionally safe segments and tenants are now riskier. We are, of course, generalizing here and not all retail loans are created equal. Competition, tenant mix, location and management all play a part. There are some 85 major tenants that banks are exposed to that are currently having problems and are responsible for property specific credit risk. Prior to the downturn, it was the “C”-quality properties in tertiary markets with strong competition and short-term leases that had the highest probabilities of defaults. Now, over the last 18 months, many “A” and “B” properties in secondary suburban markets now have higher probabilities of default.

Many of these larger properties are anchored by struggling large retailers that have been underperforming and are in a multi-year process of right-sizing their selling square footage. Different than years past, retail space with lower-quality credit tenants now are exhibiting a binary outcome where lease defaults by these anchor tenants trigger co-tenancy issues leading to immediate and exacerbated loan losses for banks.

On the positive side, banks need to take into account a new breed of tenants that they may not be familiar with. In Florida for example, we see more retail space being take up by gyms and minute clinics, two business categories with limited credit history in a retail setting. To that point, the new trend is online stores that want a physical presence (Warby Parker, Rent The Runway, Amazon, etc.), here, no credit experience exist in banking so projected defaults are anyone’s guess. Finally, more international retailers such as Primark and Uniqlo are taking spacing forcing us to conduct more international underwriting.

Mitigating The Risk

To mitigate the risk of higher retail probabilities and loss given defaults, banks need to tighten up credit requirements and conduct more tenant due diligence. Ensuring a diversified mix with a variety of lease structures and high lease quality will protect the bank during a downturn. Running a stress test on cash flows will help banks understand potential cash flow volatility as well an unveil how co-tenancy clauses in leases impact credit shocked economics.

Every credit memo should contain an analysis of new and renovated space plus traffic trends to the property should be noted. Every transaction should be priced on a through-cycle perspective taking into account expected probabilities of default and loss given default. Using these forward probabilities of default, pricing can be adjusted to help mitigate the risk.

Below, you can see where our model had and now has the expected loss for the retail asset class (based on a portfolio with an average of 1.4x DSCR and 68% LTV). As can be seen, risk is up an average of 39% from 2013. Banks need to choose their projects carefully and when warranted, tighten their underwriting standards to achieve better debt service coverage and lower leverage.

Retail has been a major source of profits for community banks, but the risk of the retail asset class has recently grown and is projected to grow. Look for credit spreads to continue to increase and capitalization rates to move up as the retail market reaches a new equilibrium. Given the rapid changes in the segments, community banks must make sure their retail shopping cart of loans does not flip upside down and turn into a credit cage.