Even as retail owners and investors are still trying to wrap their heads around higher financing costs, a silver lining is emerging: Most lenders are back at the table with capital to finance retail properties.

Lenders that shied away from shopping centers during COVID were pleasantly surprised with how well rent collections held up and how quickly foot traffic returned. “The outlook on retail from a lender’s perspective has been positive and trending in a more positive direction in the past two years, and we expect retail lending to be very active in 2023 and beyond,” said Northmarq senior vice president and managing director Chad Owens.

“Retail has really made a strong comeback and is considered a preferred asset class again among the lending community,” agreed Marc Sznajderman, senior vice president and head of production for the eastern region at Marcus & Millichap Capital Corp. Consumers have gone back to the stores, and the pace of store closings and bankruptcies has declined dramatically since the Great Recession. Marcus & Millichap Capital Corp. closed over $2 billion of retail financings last year, including both acquisitions and refinancings. Those loans were made across more than 100 unique sources of capital, which is a testament to the strong lender appetite to retail, added Sznajderman.

Marcus & Millichap has seen strong demand among banks, credit unions and commercial mortgage-backed securities for high-quality net lease retail, community centers, grocery-anchored centers and strip centers. “Even power centers have seen dramatic improvements in credit quality of tenants as the weaker big boxes have washed out,” said Sznajderman. Life insurance companies regularly will bid for well-positioned retail assets, as well, although at more-conservative levels than the banks or CMBS. He noted that enclosed malls and lifestyle centers that are in strong locations with top-tier management are seeing active bids, too, but on a highly selective basis.

More good news for borrowers seeking long-term financing is that rates have improved since last fall. Since peaking at 4.22% last November, the 10-year treasury has dropped about 50 basis points. “We have seen benchmark rates come down and lender spreads compress some because they all have big allocations for 2023, similar to what they had in 2022,” said Owens. The expectation is that it’s going to be harder for lenders to place capital this year in a market where higher rates are still putting a damper on transactions. Lenders are feeling competitive pressure that has resulted in reduced rates, noted Owens.

Finding the Right Capital Match

The continued liquidity in the market is good news for borrowers, but there’s still wide variance in the terms and loan structures available, depending on the credit quality of an asset, the strength of the borrower and the amount of equity a borrower is bringing to a deal. The biggest challenge in the current market, aside from higher costs, is finding the right solution, noted Owens. “There is still plenty of liquidity in the market. It’s just pairing the right lending options with the borrower’s expectations and wants,” he said.

More and more borrowers want shorter-term financing options with more flexibility, which would give them the ability to sell assets if cap rates compress or to refinance and increase leverage if interest rates fall. “In a perfect world, everyone would love to have 10-year fixed rate money but have flexibility after Year Two,” added Owens.

Another question for borrowers in today’s market is how much leverage a lender is willing to provide. Loan-to-value levels are more constrained due to higher interest rates and the need for lenders to hit their debt service coverage ratios. At a minimum, most life insurance companies want to be at least a 1.25x. In order to get a lender’s best pricing and terms, a borrower will face a higher DSCR, likely pushing to 1.5x on a 25-year amortization schedule, according to Blake Hering Jr., a principal at mortgage banking firm Gantry. “In good times, leverage typically exceeds 65%,” he said. “In today’s market, it is difficult to get to that level and we’re telling borrowers that they can expect 55 to 60% or less as a maximum.”

Northmarq does see opportunity to push leverage higher with the help of some creative structuring. “We have had some pretty good success trading some recourse for leverage in the middle-market life company space to get up to 75% leverage,” noted Owens. However, those are going to be higher cap rate deals that can accommodate the necessary DSCRs, he added. For example, Owens recently arranged acquisition financing for 5Rivers CRE’s purchase of The Shoppes at EastChase, a 388,700-square-foot big-box retail property in Montgomery, Alabama. The Class A property features 85 stores and restaurants with anchors that include Target, Dillard’s and Kohl’s. Northmarq was able to secure a 72.5% LTV loan from a national bank that was structured with a 10-year term, including four years of interest only that was followed by a 30-year amortization schedule.

Lenders Remain Cautious

Lenders are understandably cautious with some segments of the retail market that are performing better than others and with some continued shakeout among major tenants like Bed Bath & Beyond. Lenders also are concerned about weakness in certain categories, such as movie theaters and some fitness tenants. Grocery-anchored retail has been the front-runner among retail types most desired by lenders, with malls at the other end of the spectrum. However, while lenders are selective on the deals they’re willing to do, there is financing available for all types of projects.

Although many banks have remained active, broader pullback on CRE lending is expected, due to regulatory scrutiny and loan loss reserve requirements. “They are really holding what money they have for existing relationships,” said Hering. Life insurance companies have been a reliable source of capital and a good option for borrowers seeking long-term, fixed-rate capital with leverage below 55%. “Their leverage might be slightly conservative, but the deliverability is far more certain than what we are seeing from several of the other capital source types,” he added.

CMBS can be a more challenging option for borrowers. While once again there is demand for retail assets within CMBS loan pools, borrowers have to navigate fluctuating rates and the risk that bond buyers may lose their appetite somewhere along the way. So those transactions can go through some fairly significant changes, noted Hering.

Growing Gap Between Short- and Long-Term Debt

Lenders are expected to continue to act defensively until rates stabilize and there is more certainty in the direction of the economy. The inverted yield curve also highlights the divergence that exists between short-term and long-term financing. The expectation is that the Secured Overnight Financing Rate benchmark will increase further as the Federal Reserve continues to battle inflation. The cost of floating-rate debt and continued challenges with construction costs are making it harder to finance new development, value-add projects and heavy renovations.

In contrast, the outlook for longer-term financing is more favorable. “Assuming five- and 10-year treasuries continue to decline or at least stabilize in the 3.25%-to-3.75% range, we would expect lenders to tighten their spreads later in the year as they seek to hit production targets for 2023,” said Sznajderman. Other positives that support liquidity are that the economy continues to be resilient, particularly with strong job and wage growth, and that banks generally have strong balance sheets. “Although they are being cautious currently, we expect the posture to turn more bullish later in the year,” he added.

After an exceptionally long-running, low-interest rate environment, it has been difficult for borrowers to adjust from 3% money to a market in which rates have trended higher. “The key takeaway is that there is still plenty of money to lend and lenders are still interested in placing that money in the market,” Hering said. “It’s just a matter of adjusting to today’s risk environment relative to interest rates.”