Retail CRE: Which Deals Get Renegotiated?

One answer: new, incremental deals in outlying areas. Calculated Risk put up this post a few days ago:

“We’re dumbfounded. We’ve been working on this deal for four-and-a-half years. I don’t know how, all of a sudden, the numbers don’t work.” JMW Development Principal Mark Johnson

From the Minneapolis / St. Paul Business Journal: SuperTarget planned for Woodbury now on hold (ht Arnold)

“Target recently informed JMW that it would not proceed with the project unless it receives “a pretty significant discount” from its previously negotiated deal, JMW Principal Mark Johnson said.
“We’re dumbfounded,” Johnson said, noting that Target officials had told him as recently as June 24 that the project was on track.”

Maybe Target has lowered their retail sales estimates for the store? Just saying ...

Woodbury is an outlying Minneapolis-St. Paul suburb, and already has a Target (“B” on the map below) which is eight minutes from the site of the proposed new store (“A”).

When it negotiated the deal for the new store Target was anticipating new residential growth in Woodbury which is now not going to happen. Without growth the new store won’t hit its numbers, and will cannibalize sales from the older store.

General Growth Properties and Distressed Sales

Pre-bankruptcy, General Growth Properties refused to sell properties at discounted prices. From an April 27, 2009 Bloomberg story:

Simon Property Group Inc., the largest U.S. shopping-mall owner by stock-market value, tried to buy real estate from rival General Growth Properties Inc. before it filed for bankruptcy, Chief Executive David E. Simon said.

“They didn’t realize they were a distressed seller,” Simon said in a panel discussion at the Milken Institute Global Conference today in Beverly Hills, California. Few commercial real estate sales are being completed because sellers aren’t willing to take losses on their investments, Simon said.

Is this likely to change now that GGP is in bankruptcy? It seems not. From a May 20, 2009 Bloomberg story:

General Growth Properties Inc., the mall owner that filed the biggest real-estate bankruptcy in U.S. history, may not have to sell any malls at discounted prices, said the head of rival Taubman Centers Inc.

“Even with a distressed owner of a good quality regional mall asset, you rarely, rarely see distressed pricing of those assets,” Chairman and Chief Executive Officer Robert S. Taubman said in a telephone interview. “If you’ve got a great one, no one’s going to want to sell an asset like that at a distressed price.”

…Taubman, whose Bloomfield Hills, Michigan-based company has 24 regional malls, said the court likely will support a plan by General Growth management to keep the company’s portfolio together and emerge from bankruptcy without selling off a large number of properties.

As I discussed in my post “Is General Growth Properties in Denial?”, the GGP bankruptcy was not about fundamentals, it was about maturing debt. That’s a problem that is relatively easy to solve in bankruptcy court without liquidating assets.

Is General Growth Properties in Denial?

The CEO of one of their largest competitors thinks so. From an April 27, 2009 Bloomberg story:

Simon Property Group Inc., the largest U.S. shopping-mall owner by stock-market value, tried to buy real estate from rival General Growth Properties Inc. before it filed for bankruptcy, Chief Executive David E. Simon said.

“They didn’t realize they were a distressed seller,” Simon said in a panel discussion at the Milken Institute Global Conference today in Beverly Hills, California. Few commercial real estate sales are being completed because sellers aren’t willing to take losses on their investments, Simon said.

With due respect to Mr. Simon, I don’t think that’s the real issue; the real issue is GGP doesn’t want to give up properties at fire sale prices when they can still service their debt. General Growth Properties report on first quarter results says their net operating income on consolidated properties was $509,085,000 while their interest expense was $328,489,000. That’s a 1.55 debt service coverage, which is generally regarded as a conservative ratio. Loopnet provides an example of an individual GGP property:

…the roll of loans added to special servicing in April only includes one substantial General Growth loan, a $165 million mortgage on the 939,085-square-foot Jordan Creek mall in West Des Moines, Iowa. The loan, securitized through JPMorgan Chase Commercial Mortgage Trust, 2005-LDP5, matured in March. According to servicer data compiled by Realpoint, the property generated $19.6 million of net cash flow last year. That's 1.8 times the cash flow needed to fully service its amortizing debt.

GGPs immediate problem is not the inability to pay debt service; it’s loan maturities. From their quarterly report:

The Company intends to pursue a plan of reorganization that extends mortgage maturities and reduces its corporate debt and overall leverage. We intend to work with our various lenders and other constituencies to emerge from bankruptcy as quickly as possible while executing on a plan of reorganization that preserves GGP's integrated, national business operations.

There’s no reason at this point to expect GGP can’t successfully reorganize in such a manner, because income at their properties is actually holding up fairly well (more on that at this Traffic Court post).

I’ve previously posted on the maturity issue and worked through the numbers in some examples here.

Roads Before Roofs, Roofs Before Retail

The stories and video of new houses being demolished in Victorville are continuing to pop up in blogs and other news sources (see Calculated Risk, the LA Times, and the Wall Street Journal, for example). It’s a compelling story, but the way it’s being presented almost everywhere is misleading.

First, here’s the video if you haven’t already seen it:

The video, and every story I’ve seen referencing it except one, gives the clear impression the bank thinks it makes economic sense to demolish completed and virtually completed but unsold houses because the market is so bad. However, the original source of the story (see this post) interviewed an officer at the bank, who makes clear the real issue is the homes were built before the roads and other site improvements were completed. Completed homes could have been sold at some price, but if there’s no road to the home you can’t sell it.

This is obviously bad construction lending practice; you should complete site improvements first (or make sure you’ve held back enough money to do so). Hence the headline, roads before roofs. This seems obvious, but it happens more often than you might think. When I was at Capmark a few years ago one of our workout deals was a project where we funded the equity portion of a purchase of a multifamily land parcel, and then discovered the access road we needed couldn’t be built because it would cross a stream which was the home of an endangered fish species. That investment was a total loss.

It’s also obvious it takes more than a few mistakes to bring down a lender, but when you have a major due diligence breakdown like this, you have to wonder if it’s not the tip of an iceberg of bad decisions. From the WSJ story linked above:

Guaranty Bank has significant exposure to construction loans to home builders. Last month, its parent company, Guaranty Financial Group, was issued a "cease and desist" order by the federal Office of Thrift Supervision, citing the firm's "unsafe and unsound banking practices."

I’ve previously posted about Capmark’s problems here. Since then, they reported a $1B loss in the first quarter.

The second part of the headline is roofs before retail. Before you develop a retail project, you want to make sure there are enough people living in the market area to support it. Because subdivisions were being developed at such a rapid rate, this rule was frequently violated, and when the music stopped on the residential side many retail projects were left without a customer base. Between the two retail sites indicated below, which do you think is doing better?

The lesson is, it’s important to develop in the right order; infrastructure, then residential, then retail.

Retail, Co-Tenancy Clauses, and Ecological Cascade Effects

National Real Estate Investor has a story detailing the effect co-tenancy clauses are having on retail centers. An excerpt:

As retail chains close unprofitable stores across the country, remaining tenants at the shopping centers are increasingly invoking clauses in their leases that give them the right to pull out of a center without penalty, placing new financial strain on the property owner. At times the added burden of losing additional income is so great that it pushes the owner toward bankruptcy.

Called co-tenancy clauses, the legal passages in tenants’ contracts often say that if a major anchor such as Macy’s or Best Buy leaves the center, then they have the right to a remedy — from rent reduction to withdrawing from the center in order to seek a more profitable location. That is posing a widespread problem for shopping center owners, says real estate attorney Irwin Fayne, a partner at Holland & Knight in Fort Lauderdale, Fla.

This is a real estate variation of an ecological cascade effect:

An ecological cascade effect is a series of secondary extinctions that is triggered by the primary extinction of a key species in an ecosystem. Secondary extinctions are likely to occur when the threatened species are: dependent on a few specific food sources, mutualistic(dependent on the key species in some way), or forced to coexist with an invasive species that is introduced to the ecosystem.

Small retail tenants, of course, are dependent/mutualistic with draw retailers – they hope to capitalize on customer traffic created by the draw tenant. There is also a retail variation on being forced to coexist with an invasive species. From Surplus Real Estate.com:

Just think how happy a clothing retailer is when the K-Mart store turns into a lumber yard.

Too Much Retail Space in America

TWR had an interesting article this week titled Going Beyond Core Retail Sales Growth (note: free registration required). Here’s a chart of real retail sales per square foot of retail space:

There seems to me to be a clear link between this trend and the tremendous expansion of retail outlets See this link for visualizations of Target and Wal-Mart expansion. Do we really need all those stores?

Economic and Real Estate Post Picks: Week of February 16, 2009

Deflation Risk Down but not Out: The declining risk of deflation

Six Retailers that are Thriving: Some obvious (Wal-Mart), some not (Best Buy?)

Sales Tax Collections Plunging: Bad news for state and local governments

Is There a Treasury Bubble?: Lots of supply coming, but also lots of demand

Tracking the Household Balance Sheet: Income and debt flat, but net worth down substantially

Economic and Real Estate Post Picks: Week of February 9, 2009

How Bad is the Employment Picture, Really? Recession comparisons using Payroll Employment versus Household Employment data (hint: payroll employment is a better data source)

How This Recession is Different: Consumer, bank, and business balance sheets are much more leveraged then previous recessions

Real Disposable Income Up: The savings rate also improved in December

Significant Fall in Domestic Demand: The worst decline post-WWII

Retail Store Opening and Closings: Good information on trends in openings and closings by retail sector

Why CRE Goes So Bad So Fast: Vintage

During times of peak rents and occupancy levels there are a lot of loans done using aggressive underwriting parameters, and when market conditions soften those loans all go upside down at once (see a discussion of this and other factors in this post).

Here is an illustration from the New York Times, via Calculated Risk:

[M]any landlords find themselves in a bind because they paid stiff prices for property in recent years and need to cover hefty mortgage payments. On average, Manhattan landlords paid $3,348 per square foot for retail properties in 2008, compared with $538 per square foot in 2004, according to the brokerage Cushman & Wakefield.

Loans underwritten in 2004 based on the lower value will fare much better than loans underwritten in 2008.

Retail Outlet Saturation: Target and Walmart

Very cool visualizations of the growth in Target and Walmart locations since the inception of the retailers:

Target

Walmart