INSIGHT VIEWPOINT ELIZABETH CRAWFORD FEBRUARY 10, 2017 The CMBS market is in the late stages of the credit cycle with CRE valuations and conduit CMBS leverage above pre-crisis peaks. 1 The majority of valuation gains this cycle are the result of cap rate compression, rather than net operating income (NOI) growth, which makes property values vulnerable to decline in a rising rate (and rising cap rate) environment. To mitigate the leverage inherent in full valuations unsupported by NOI growth, we ve concentrated positioning at the top of the capital stack and added exposure to Single Asset Single Borrower (SASB) bonds that have more conservative trust leverage. Given the late-cycle nature of credit, we ve focused our CMBS exposure on properties that better-maintain their NOI and value throughout cycles namely higher quality properties in the best MSAs with well-capitalized sponsors and superior operating metrics. Elizabeth J. Crawford Vice President U.S. Fixed Income Ms. Crawford is a CMBS trader in the Securitized Products Division of the U.S. Fixed Income group. She joined TCW in 2015. Before joining TCW, Elizabeth was a portfolio analyst covering structured products and commercial and residential REIT equities at EJF Capital LLC ( EJF ), a $7bn multi-strategy alternative asset manager in Arlington, VA. Before joining EJF, Ms. Crawford was an Associate in the Securitized Products division at Credit Suisse. She started in institutional sales covering ABS, MBS, and CMBS investors before moving to asset finance, where she focused on residential mortgage banking and securitization. Ms. Crawford holds a BA in Political Science and International Studies from Yale University. Retail bankruptcies and mall closures drew headlines in 2016 and we expect this trend to continue as the retail landscape right-sizes. Department stores have experienced a secular decline for the past decade, a dynamic trend that is accelerating due to increased competition from ecommerce and shifting consumer trends. 2 The rise of ecommerce is significant, capturing 15-20% of industry sales today, with market share projected at 35-40% of sales within the next 5-10 years. 3 Many retailers, in an effort to maintain profitability, are focused on right-sizing their brick-and-mortar footprints by closing less productive stores and expanding their online presence. If landlords cannot find a replacement for a departing tenant, their retail property will suffer from higher vacancies and lower revenue. In the worst case scenarios, a store closure typically a department store anchor can trigger co-tenancy clauses that allow other tenants to pay reduced rent and/or terminate their leases. The most at-risk retail properties for tenant closures are less-productive malls and strip centers, located in areas with low population density and weak consumer spending. The impact of weaker productivity, store closures, and co-tenancy clauses can reduce mall valuations from hundreds of millions to land value in less than five years. When we review the retail landscape, the most glaring concern is the supply overhang of retail-dedicated space. The United States has the largest amount of retail-dedicated space per person in the world at 23.5 square feet (SF) well above the second most retail-saturated country, Canada (16.4 SF), and over twice the amount of the third, Australia (11.1 SF). 4 The current glut of retail properties is largely the result of overzealous development nationwide. The first regional mall in the US was the Southdale Center, opened in Edina, MN, in 1956. The property was designed by an Austrian architect, Victor Gruen, as a convenient shopping and socializing solution for the growing suburban population a veritable mini (and enclosed) urban center in the suburbs, anchored by two large department stores. 5 The formula was a success and the regional mall became a staple of suburban consumerism.
Rows of cars parked outside the first US mall, Southdale Center, in Edina, Minnesota. (Photograph: Simon.com) As is typical with over-development, there was an economic incentive for construction beyond delivering spaces into demand. The Internal Revenue Code of 1954 established a new tax depreciation policy as an economic incentive to stimulate investment. The new method of depreciation, called accelerated depreciation, allowed investors to concentrate deductions in the early years of service of an asset. With accelerated depreciation, mall development offered investors a source of valuable tax deductions. 6 To reduce costs and enhance returns further, developers moved construction sites from the suburbs to the cheaper land on the outskirts - deviating from Gruen s original concept of a suburban town center. The combination of suburban expansion, growing American consumerism, and favorable tax laws contributed to the astounding 1,100 malls in the US today. 7 For decades, malls offered consumers a place to socialize and shop, with landlords embracing the role of town center by hosting community events like concerts and fashion shows. A lot has changed. Today, socializing is done online as much as in person, town centers are anywhere from Main Street to the city Central Business District (CBD), and consumers can shop from any computer or mobile device. Indeed, ecommerce has revolutionized the retail industry by removing the need for shoppers to even visit a brick-and-mortar store. In the midst of so much change, many suburban malls lost their relevance to the consumer and when consumer foot traffic stops, retail properties fail. 2 A number of mall owner-operators have proactively positioned for the changing retail landscape by selling their lowerproductivity properties and reinvesting proceeds into upgrades within their core portfolio. Sales per square foot (PSF) is a common metric for mall productivity, with a minimum of $500 PSF sales indicating that a property is the dominant mall in the trade area. According to Green Street Advisors, only 300 of the country s 1,100 malls generate sales greater than $470 PSF, while the stronger REIT landlord portfolios average $580-$650 PSF. 8,9 One successful strategy employed by mall owners is to reposition their property into a lifestyle center by rotating anchors away from traditional department stores (like Dillard s and Macy s) into specialty retailers (like Williams-Sonoma, Restoration Hardware, and Apple) or entertainment tenants (such as Dave and Buster s and Lucky Strike bowling). Innovative landlords have expanded their traditional tenant mix to include high-end grocers, salons, spas, and fitness centers offering patrons more activities and convenience. In addition to invigorating the tenant mix and attractions, owners have invested in property upgrades to enhance the visitor experience. Many design upgrades include high ceilings and skylights to flood the indoors with natural light, as well as green pathways and patios to create a walking oasis a significant change from the concept of an indoor urban center.
VIEWPOINT On the left, skylights adding natural light in an indoor mall; on the right, manicured grounds for walking and a non-traditional anchor, Crate & Barrel.10 (Photographs: GGP s Portfolio) Just as landlords have to innovate to maintain consumer traffic and productive tenants, retailers have to work to preserve their brand relevance and maintain profitability increasingly difficult in an already-saturated market with growing online competition. Macy s offers an example of a proactive department store that is focused on right-sizing its brick-and-mortar footprint while growing sales through its online platform. In August 2016, Macy s announced its intention to shutter 100 stores, and in January 2017, the company identified 68 specific stores for closure.11 While strategically exiting less productive and non-core locations, Macy s has developed an omnichannel platform. Omnichannel retail platforms integrate the various methods of shopping available to consumers physical channels (brickand-mortar stores) and digital channels (online computer and mobile devices) to offer customers a seamless purchasing experience across various points of sale. While Macy s provides an example of a retailer committed to modernizing its operating model for today s retail challenges and opportunities, a number of companies have failed to innovate, often resulting in bankruptcy. In 2016, retailers such as Sports Authority Inc., Pacific Sunwear of California, Inc. (PacSun) and Aeropostale, Inc. declared Chapter 11. Looking ahead, Fitch reported that Claire s Stores, Inc., Sears Holdings Corporation, Nine West Holdings, Inc., and Rue21, Inc. all have significant default risk within the next 12-24 months.14 Retailers need sales to survive if they do not maintain brand recognition and customer business, the company fails. Macy s 250K SF Men s Store building at 120 Stockton Street in San Francisco. Macy s will consolidate the Men s store into their flagship store across the street. 12,13 3
Given our established concern about the oversupply of regional malls and the precarious position of many retailers, we cannot help but anticipate an accelerated right-sizing. From an investment perspective, the changing retail landscape requires limiting exposure to higher-risk properties and finding opportunities to add exposure to high-quality properties at attractive levels. Of the roughly $500BN CMBS market, retail represents around 30% of the underlying mortgaged properties ($150BN). Within that $150BN of retail exposure, around 30% is secured by regional malls, bringing CMBS regional mall exposure to around $50BN (10% of the total CMBS universe). Since 2010 alone, the CMBS market has securitized 357 loans ($40.54BN) backed by 320 malls. 15 The highest retail concentrations are in the 2012-2013 vintages, with CMBS lenders winning 47% of retail lending market share during that time period. 16 Since 2010, CMBS mall-backed loan liquidations totaled $3.89BN at a loss of $2.88BN (74% loss severity) to the securitization trusts. In addition to the liquidations, another $3.81BN, or 7.8% of all mall-backed loans, are currently in special servicing. 17 The extraordinary trust severities on mall liquidations are not only the result of inflated underwriting assumptions and interest only loans but importantly the properties have limited inherent value when they fail as a mall. There have been efforts to repurpose failed malls; however, the completed repositionings typically occur years after the CMBS default and liquidation. Furthermore, many malls to do not have a ready next use or a community committed to repurposing the space, often making demolition the best outcome. Mall declines can escalate quickly, as many lease obligations include co-tenancy provisions that offer tenants termination options and/ or reduced rent options if named stores close most often department store anchors. These co-tenancy clauses are the reason investors should carefully review mall productivity metrics such as sales per square foot (PSF) as well as anchor strength, and published store closings. The average sales productivity of the malls affected by Macy s announced closures is $338 PSF, with over 90% of the malls producing sales less than $400 PSF. 18 The trend is clear weaker performing malls will face the brunt of store closures. Aventura Mall in Aventura, FL, on the left and Queens Center in Elmhurst, Queens, NY on the right. As weaker malls face their reckoning, dominant malls often called fortress malls continue to do extremely well. The Aventura Mall, located in a suburb of Miami, produces in-line sales PSF above $1,400 with over 28 million visitors per annum. 19 Queens Center, located in Elmhurst, Queens, produces sales PSF of $1,100 with over 18 million visitors each year. 20 There are a number of very high quality retail properties that will continue to capitalize on consumer demand, in light of growing online sales and shifting consumer preferences. We recommend focusing investments on these high quality assets and limiting exposure to the hundreds of regional malls that face obsolescence. The retail landscape is changing from one of exuberant consumption concentrated in regional malls to a more discerning consumption allocated across online and brick-and-mortar platforms. The failure of once-vibrant retail properties and the significant loss severities incurred as a result remind us that property valuations are fickle and that leverage can be misunderstood. As we review investments in the late stages of the credit cycle, we are acutely aware that price appreciation, unjustified by gains in net operating income (NOI), makes properties particularly vulnerable to economic stress and reduces principal protection in the event of idiosyncratic risk. We continue to position at the top of the capital stack and focus exposures on higher quality properties, located in the best MSAs, with wellcapitalized sponsors and superior operating metrics. 4
Sources 1 Moody s/rca CCPI indicating CRE prices are 23% above their pre-crisis peak (a 169% recovery of peak-to-trough losses) and leverage in conduit CMBS, as measured by Moody s Loan-to-Value (MLTV) ratios, at 118.1% - above the 117.5% pre-crisis peak 2 U.S. department store sales have been on a steady decline over the past decade, shrinking from $87.46 billion in 2005 to $60.65 billion in 2015, according to U.S. Department of Commerce figures. https://www.emarketer.com/article/u.s.-department-store-sales-declining/1014629#sthash.tvxjley9.dpuf 3 CS Research: Department Stores & Off Price Sector Review, The Four Keys for Broadlines Survival; Real Estate Redution, ecommerce, Speed, Brands 4 Morningstar Report Mall Monitor Examining the State of U.S. Malls With Attention to Retail, October 2016. 5 Smithsonian.com, The Death and Rebirth of the American Mall http://www.smithsonianmag.com/arts-culture/death-and-rebirth-american-mall-180953444/ 6 Accountingin.com http://www.accountingin.com/accounting-historians-journal/volume-27-number-2/the-role-of-depreciation-and-the-investment-tax-creditin-tax-policy-and-their-influence-on-financial-reporting-during-the-20th-century/ 7 The Guardian; https://www.theguardian.com/cities/2015/may/06/southdale-center-america-first-shopping-mall-history-cities-50-buildings 8 Morningstar Report Mall Monitor Examining the State of U.S. Malls With Attention to Retail, October 2016. 9 REIT earnings; MAC 3Q.16 Supplemental, SPG 3Q.16 10Q p.36, GGP 4Q.16 Supplemental p.17; GGP November 2016 NAREIT presentation 10 GGP sustainability report; http://s21.q4cdn.com/180785755/files/doc_downloads/2016_sustainabilityreport.pdf 11 Macy s Press Releases: (1) 68 store closures, January 2017: http://investors.macysinc.com/phoenix.zhtml?c=84477&p=irol-newsarticle&id=2234057 ; (2) 100 anticipated store closures, August 2016: http://investors.macysinc.com/phoenix.zhtml?c=84477&p=irol-newsarticle&id=2194923 ; (3) Brookfield Strategic Alliance, November 2016: http://investors.macysinc.com/phoenix.zhtml?c=84477&p=irol-newsarticle&id=2221342; 12 Macy s Press Releases: Macy s sells Union Square men s store, November 2016 8K (11/10/2016) 13 RE Business Online: https://rebusinessonline.com/blatteis-schnur-morgan-stanley-acquire-macys-mens-store-in-san-francisco-for-250m/ 14 Fitch Ratings Retail Bankruptcy Enterprise Value and Credit Recoveries (September 2016) 15 Morningstar Report Mall Monitor Examining the State of U.S. Malls With Attention to Retail, October 2016. 16 Real Capital Analytics (RCA) and Morgan Stanley Research. 17 Morningstar Report Mall Monitor Examining the State of U.S. Malls With Attention to Retail, October 2016. 18 Morgan Stanley Research, REITs / Retail / CMBSignals: Mall Jenga 2: Macy s Blocks Fall with Focus Shifting to Sears January, 2017, Macy s Store Closure Analysis, January 2017 19 AVMT 2013-AVM Deal Documents 20 QCMT 2013-QCA Deal Documents This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or forward-looking statements. Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. 2017 TCW 865 South Figueroa Street Los Angeles, California 90017 213 244 0000 @TCWGroup 5