Struggling Malls Pose Outsized Risk to CMBS
Like used cars and retired pro football players, regional shopping malls do not age well.
In a span of no more than a decade, a popular mall with high-end anchor stores and boutique retail tenants can fall into substandard Class B or C property condition, left behind by shifting customer demographics or newer amenities at rival shopping centers. More so today, they also face the reality of more consumers choosing to stay home to shop online.
When these malls become passé, that's when trouble starts for commercial mortgage bond investors, who can sustain outsized losses on their exposure to these properties, compared with other kinds of collateral such as office buildings, hotels and industrial property.
In a report published Thursday, Moody's Investors Service warned that loans backed by shopping centers are an increasing cause of concern for mortgage bond investors and provided some criteria for evaluating the long-term viability of regional malls.
"The ability of a mall to adapt to this changing environment and find new ways to attract shoppers is key to its ongoing success," the report states. "Very few of the top tenants in malls 20 years ago are still strong performers — or even in still in business — today."
Moody's looked at the loss severity on loans backed by 30 regional malls that have liquidated since 2008: each averaged 75%, almost twice as severe as the 45% average for all other CMBS loan liquidations in that time period. In the case of 10 of the failed malls, the loss severity was over 100%.
Loans backed by shopping malls are typically structured no differently than other kinds of commercial mortgages: they have 10-year tenors with large balloon payments due at maturity, meaning they amortize very little during their terms. The issue is that malls can have relatively short lives as premier properties, and so may need new capital investments — and thus new financing — within a decade to expand their shelf life.
Individual malls have been under pressure to maintain their appeal and customer interest since the 1980s, but these challenges are now exacerbated by competition from online retailers, which is hitting traditional mall anchor stores like Macy's and Sears particularly hard. With a business model dependent on traffic driven by magnet department stores, malls could be in significant trouble, and as a result, perform poorly as CMBS collateral.
For example, Macy's plans to shutter 100 stores this year, a move that Morningstar Credit Ratings estimates could impact $3.64 billion in outstanding securitized commercial mortgages backed by malls with Macy's as a prime tenant.
So how can CMBS investors assess their risk?
To find out, Moody's mapped out the capabilities of local and national mall owners to keep their properties viable and profitable during long-term 10- to 20-year leases. Demographics, location and property age were not the only, or the most important, factors. Some properties like The Florida Mall in Orlando having weathered the replacement of four anchor stores over 30 years to remain a competitive shopping mecca in central Florida.
Malls that maintain upscale amenities and ties to national ownership attract high-end, non-anchor stores (or "inline" tenants, with stores under 10,000 square feet), the report noted. The healthiest malls average more than $400 in per-square-feet sales for their non-anchor stores, and have occupancy cost ratios (tenant real estate costs divided by gross sales) above 13% for its inline tenants.
Those gross sales figures for the strongest malls, as measured by Moody's, exclude the transactions from high-demand boutique retail outlets that skew sales figures, such as Apple Stores. An Apple retail store by itself can boost a mall's sales per square foot by $100, Moody's stated.
Weaker malls will usually average inline store sales of no more than $275 per square foot and have locations with limited demographics and fewer national chain tenants. If they do have chain tenants, those stores will likely have lower-than-average sales figures for than sister stores across the country.
Low traffic volume, whether due to mundane store options or too few neighboring entertainment and dining establishments, often gives malls less negotiating power with tenants over rent terms. These property owners might have to accept "gross" leases where the tenant pays a percentage of sales versus a base rent for occupancy.
Net income operating margins could fall below 65%, sometimes 50% for struggling substandard malls, compared to 70%-80% for the stronger malls that can demand excess percentages above base rents. Strong performers can also draw up "triple net" leases that foist some of the real estate expenses onto some tenants.
National sponsorship is considered a key indicator for a strong mall’s performance, with ability to provide more incentives for key anchor tenants to maintain or expand their presence. A sell-off by a national ownership group to a local owner can often trigger a mall's weakening performance — tenants may ask for rent relief or may exit the mall in the absence of a national ownership backer.
Even if weaker-performing malls demonstrate stability, investors must weigh the cost-effectiveness of when the inevitable, and capital-intensive, rehab of a mall must be undertaken. For "highly productive" malls, Moody's stated, the high cost of market repositioning or a refresh of the tenant lineup can be justified. For less-productive malls, they are often forced to sell well below par to give new owners the capital space to invest in a revitalization project.
"Depreciation for malls is not just an accounting concept; malls need to stay current and vibrant or risk a reduction in their earnings power," the report states.