Peril and promise in lending to retailers

Drugstores are not the most exciting places to shop —unless picking up a refill of a cold medicine is your idea of a good time. But loans to drugstores are the best-performing of all retail loans for one simple reason: “Drugstores are rarely vacant,” said Joe McBride, an analyst at the commercial real estate data firm Trepp.

Indeed, in an examination of loans backed by drugstores, Trepp determined that a whopping 99.8% of those properties were occupied.

Trepp analyzed about 17,000 retail loans that have been packaged into commercial mortgage-backed securities. It found that more than 70% of all CRE loans for drugstores placed in its top 20% ranking of commercial mortgage-backed securities, based on such crucial metrics as occupancy rates and net income per rentable square foot. Drugstores generated an average $23.34 of net operating income per square foot, higher than the $17.90 average.

The takeaway: Bankers looking to add high-quality CRE credits to their portfolios should look very closely at pharmacies and drugstores.

Large retailers present an intriguing, though potentially hazardous option for lenders. It’s a high-risk, high-reward category that may not be for the faint of heart.

According to Trepp, retailers that occupy at least 95% of the rentable space, generate an average of $23.17 in net operating income per square foot, or almost as much as drug stores.

Retailers in this category, which Trepp describes as single-tenant properties, include the likes of Home Depot, the health club chain LA Fitness, grocery stores and selected single-brand apparel chains.

But many single-tenant retailers are also struggling to compete with Amazon and other online retailers and in recent years have closed hundreds and hundreds of stores. They include such household names as Sears, Toys R Us, Mattress Firm, Neiman Marcus and JCPenney.

Trepp did not provide data on the performance of loans that back the properties for these types of retailers. But considering that many creditors lost money when Sears and Toys R Us filed for bankruptcy, it stands to reason that landlords of those now-vacant properties might struggle to keep up with their loan payments.

Recent sales numbers illustrate just how challenging it can be for lenders to determine which retailers are good credits. Overall retail sales for the crucial month of December fell an adjusted 1.2% from the same period in 2017, according to government data released last month. The figure had been projected to rise 0.1%. While the data reflects activity at both brick-and-mortar and e-commerce retailers, traditional retailers feel the pain more acutely due to their higher real estate costs.

But some individual retailers are seeing solid growth. Target said Tuesday that year-over-year same-store sales increased 5.3% in the fourth quarter and projected similar growth in 2019. Rival Kohl’s said same-store sales in its fiscal-year fourth quarter climbed 1%, well above analysts’ estimates of 0.3%.

Trepp’s McBride said that the message for banks is that there are good, big-box loans to be made out there if they know where to look.

“It would be irresponsible for us to press the panic button and conclude that the U.S. retail market is a failing industry,” he said.

Trepp says that loans on strip centers are among the worst performing in commercial real estate, and there are two big reasons why: Occupancy rates are consistently mediocre and net operating income per rentable square foot is among the lowest of all retail loan types. The average net operating income for community shopping centers was $11.02 per square foot, below the $17.90 average for all property types.

Community shopping centers are typically occupied by merchants that peddle general merchandise or convenience-oriented offerings — nothing that would generate much excitement among consumers, or that couldn’t be purchased online.

Some strip malls, of course, are healthy and host a steady stream of traffic, McBride said. But some community shopping centers are frequently deserted, particularly those located outside major urban or suburban markets.

It’s little wonder, then, that bankers are less than enthused about lending to owners of strip centers.

“We don’t do anything meaningful in strip malls,” Chuck Sulerzyski, CEO of the $4 billion-asset Peoples Bancorp in Marietta, Ohio, said in a Jan. 22 conference call.

Bankers are also becoming increasingly skittish about making loans to developers of large shopping malls.

During a presentation to investors in November, Clarke Starnes, the chief risk officer at the $219 billion-asset BB&T, said that the bank is being “very intentional about governing down CRE exposure limits” and now has “almost no exposure on the mall side.”

In Trepp’s study, mall-backed loans accounted for the highest number of delinquent loans of any retail property type. (Trepp did not provide a breakout of data for delinquency rates.) Additionally, regional malls had an average occupancy rate of about 93%, the lowest of any property type.

Even lenders with strong track records in CRE lending have been getting burned by defaults on loans to mall developers.

Last year, the $22 billion-asset Bank OZK in Little Rock, Ark., charged off about $46 million to cover two problem loans. One of the properties was a regional mall in South Carolina anchored by Sears and JCPenney.

When certain market segments are struggling, government subsidies and tax breaks can go a long way to help.

With that in mind, bankers may find viable opportunities lending to retailers located in Opportunity Zones. A new federal rule provides tax benefits to investors who put money into projects located in these specially designated low-income neighborhoods.

More than 8,000 communities in every state have been designated as Opportunity Zones. And investors are lining up, making more than $2.6 billion of investments in the zones in December, an 8% year-over-year increase, according to the real estate data firm CoStar.

The neighborhoods earmarked for Opportunity Zone investments typically lack many retail options, which could create the potential for retail loan originations for banks.

These investments will make it easier for banks to originate loans for projects in low-income communities that otherwise would not meet their underwriting standards.

Banks could see an uptick in both construction-and-development loans for retail centers and for the permanent mortgage on these retail properties.