How to Improve Retail Financing Prospects

Why an effective leasing strategy is critical in order to secure funding for retail properties, according to Transwestern Senior Vice President Larry Jordan.

Larry Jordan, TranswesternMarket forces in 2018 seem intent upon thwarting retail real estate financing, whether for acquisition, construction or the replacement of maturing debt.

Many retailers are struggling to right-size, attempting to strike a balance between online and brick-and-mortar sales that enables them to remain profitable and competitive. News coverage that focuses on store closings, while largely ignoring retailer expansions, has made lenders and investors increasingly wary of the sector. And nearly 10 years into an economic growth cycle, fears of an eventual correction raise the bar for borrowers extolling their projects’ loan-performance capacity.

Look to leasing

In many cases, the most important prerequisite for financing or refinancing is to create value with healthy occupancy by well-performing tenants. In the case of new construction, commitments from good-credit users with a solid financial sponsorship can fulfill the occupancy requirement.

Landlords may be tempted to let a struggling big-box tenant give back all or a portion of its space, with the expectation of finding new and more stable tenants to backfill the opening. Unless the landlord has a replacement user in tow, however, it is usually better to retain the tenant, even if that requires a rent reduction. This is especially true before applying for refinancing.

The immediate risk of a dark store is lost revenue and the resulting decline in property value. In addition, remaining tenants may experience reduced foot traffic and customer engagement. Lower sales per square foot, coupled with lost rental income on the vacant space, detract from the asset’s value.

Vacancies can snowball, too, due to co-tenancy clauses. If a big-box store vacates, the landlord typically has a year to bring in a replacement. If the space remains empty beyond that period, the other large tenants, in most cases, can either terminate their lease and leave, or stay at a reduced rent—usually 50 percent of their original rate. This eats away at property value and borrower equity.

Stay above water

CMBS loans due in 2018 may have been issued near peak property values in 2007 or 2008. Many of these loans included interest-only periods, which means the balance due hasn’t been paid down as much in comparison with fully amortized loans. Here again, occupancy may be a deciding factor in the borrower’s refinancing prospects.

Properties with too much vacancy will no longer appraise at sufficient value to meet a new lender’s loan-to-value ratio, or may be worth less than the remaining loan balance. Landlords in that situation may require a new strategy, such as non-traditional tenants to fill empty spaces, perhaps trading a lower rental rate to obtain lease commitments that bring the property value to the required level.

Expect any new debt to be costlier than it was a few years ago, given the recent rise in interest rates. Lenders will require borrowers to contribute more equity— 30 to 35 percent, on average—compared with the 25 percent that was typical several years ago.

Financing is still available for retail properties. A strong leasing strategy implemented successfully is the key.

Larry Jordan is a senior vice president on the Capital Markets team at Transwestern, specializing in retail.