Every year we update our projections on national retail tenants that show higher than average risk of shutting down or having financial problems that elevate probabilities of default in retail centers where banks have loans outstanding. Some of these are obvious and have been in the news for years. However, others, despite the strong economy and record low unemployment, may just not be relevant going forward and either have a tired business model, are being impacted by online retailers, are being impacted by alternative channels (i.e., pop-ups, food trucks, farmer’s markets, etc.) or are caught in the trend of urbanization.
Layer on that higher interest rates, a strong dollar hurting foreign investment in retail properties and potentially higher tariffs on foreign-made goods and you have the potential for higher commercial lending risk for community banks in the retail sector. In this article, we detail the 22 retailers that are on our watch list plus update our view of retail lending going forward.
The Problem With Retail
In the commercial lending area, retail remains the sector with some of the highest projected probabilities of default. Not only are more consumers forgoing brick-and-mortar stores and moving online, but the US remains saturated with retail space. Consider that in the US, we have 23.5 square feet of retail space per person. That is the highest in the world and is materially higher than the two next highest retail-laden countries being Canada at 16.4 square feet and Australia at 11.1 square feet. We simply have too many stores and with the 79% of American’s now shopping online (according to a December Pew Research Poll), we look for more stores than ever to close.
Below is our list of at-risk tenants that we generate so that we can A) monitor our current portfolio, and B) adjust pricing or underwriting criteria on new transactions with these tenants.
Some of the retailers below are large box tenants that could cause a major issue if the space goes dark, while others usually have smaller space, but are still material. As we have pointed out before, one issue in lease structure risk is the level of “co-tenancy clauses” that are contained in these retail leases that allow the remaining tenants to terminate their lease or restructure terms such as pricing if a major tenant leaves.
Here are 22 tenants that are at most at risk for closing stores in the U.S. in 2017:
American Eagle Outfitters
The Children’s Place
The Strength and Risk of Retail
We don’t want to give you the impression that it is all doom and gloom. Retail still enjoys a 95% occupancy rate for the start of 2017, about the same as 2015 and 2016. Chains like Whole Foods, Panera, Planet Fitness, Tim Horton, Dunkin’ Donuts, Starbucks, HyVee and many others are doing well and are looking for new retail space. However, our point is only that from a lending perspective, now is the time to be careful and pay particular attention to tenant risk and structure.
Since April of last year, retail risk has been steadily rising from 5.0% to 6.0% probability of default at the start of 2017. In addition to the above trends, there is also higher interest rates and less foreign investment because of the stronger dollar that will also be slowing retail real estate growth and increasing capitalization rates from 4.5% to 4.8%. We predict rents will decrease slightly on a real basis and drop below the $20 per square foot national threshold.
While we look for 2017 to be similar to 2016, there will be some pitfalls tenant risk being among the greatest. This means that community banks should choose not only their properties wisely, but also be concerned about neighboring traffic patterns when impacted by the above retailers. Where appropriate, increasing credit quality and dropping price, or maintaining credit quality but increasing pricing will help mitigate a portion of this higher incremental risk. In addition, banks need to conduct additional tenant credit shocks, while making sure they understand and capture the risk of co-tenancy clauses.
Submitted by Chris Nichols on January 17, 2017