Long before the pandemic struck, retail property lenders and investors started favoring assets they believed would thrive amid changing consumer preferences and rising e-commerce sales. Since then, the pandemic has accelerated changes in the way retail and mixed-use are underwritten and has given rise to others. Here’s how.

The field of lenders has narrowed: Banks have become the primary source of financing for retail properties, though they’ve become more conservative with underwriting.

According to Real Capital Analytics, banks were responsible for a whopping 72 percent of retail property loans in 2020. Banks’ share of lending on retail properties rose dramatically, from 52% on average in 2018 and 2019, not because they became more aggressive but because other purveyors of capital pulled back from the sector.

As measured by average loan-to-value ratios, banks, particularly domestic institutions, have become more conservative in underwriting retail properties over the past year. While the average LTV on retail properties for international banks rose slightly, from 61% in 2019 to 62% in 2020, the opposite was true for national, regional and local banks. The average LTV on retail properties for national banks fell from slightly more than 64% in 2019 to 62% in 2020. For regional and local banks, it dropped nearly 1 percentage point to 66%, according to RCA.

In all, bank originations of retail property loans, which tend to correlate with sales activity, dropped by about 58 percent in 2020, according to the Mortgage Bankers Association.

Lenders show a preference for mixed-use projects that incorporate apartments, an asset class that has held up well during the pandemic and is expected to see strong demand going forward.

Lenders hunkered down to manage their property-loan portfolios through the pandemic rather than make new loans, said MBA vice president of commercial real estate research Jamie Woodwell. Now, banks are seeking deals again, but they’re focused on properties that have seen little disruption to net operating income during the pandemic and that are expected to benefit from demand tailwinds, according to Woodwell.

In late 2020, loan demand and lending on industrial and multifamily properties was robust, while there was a corresponding drop in activity for retail, hotel and office, he said. Industrial and multifamily “are the two property types that have come through the pandemic most cleanly and with the fewest questions about what’s next for them,” said Woodwell. Given that lenders tend to be bullish about multifamily, it’s not surprising they’ve developed a general preference for mixed-use projects with apartment components rather than those with significant space devoted to hotel or office.

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“A mixed-use retail project that had a high component of value placed on a hotel project a year ago looks very different today than it did at the end of 2019 because the hospitality world has been hit relatively hard by the pandemic,” said Frost Brown Todd attorney Geoffrey White, who represents borrowers, developers, owners, investors, lenders and loan servicers. “Mixed-use projects with office components are also a bit difficult for lenders to get their arms wrapped around, particularly if there is significant vacancy for peer [office] projects in a given submarket. Some office projects are really struggling, yet others are doing very well. So it really becomes a location, location, location issue.”

White suggested a proactive approach when seeking financing for a mixed-use project that replaces one use with another, such as a conversion of vacant retail anchor space to apartments. One step, he said, would be to try to renegotiate any existing covenants, conditions and restrictions and reciprocal easement agreements with tenants and other parties. Doing so would help lenders better understand the intricacies of a proposed project, said White. “As we’re not talking about a simple construction loan, taking this first step demonstrates to lenders that your potential mixed-use concept is a distinct possibility. Negotiations over REAs and CC&Rs are oftentimes complex and involve many parties. It's important to have a lender that understands and appreciates the challenges that might await any such major changes to the property,” he explained.

To manage risk, lenders are paying closer attention to properties’ NOI trends and co-tenancies and the track records of owners, managers and leasing teams.

JLL Capital Markets Americas managing director Claudia Steeb said lenders dig in more on retail and mixed-use deals than they did prior to the pandemic — and that’s not necessarily a bad thing. “Lenders are digging deeper and asking a lot more questions prior to issuing a term sheet or a loan application or even going to a preliminary committee” internally, she said. “So it’s a longer process upfront, but, in my opinion, it tends to be a better process because you have a deal that has at least been vetted during round one internally.”

The underwriting process, said Steeb, now focuses heavily on the sustainability of a given property’s NOI, which ties in part to tenant sales relative to rents and to the property’s lease expiration schedule. Lenders, she said, now pay close attention to how a property’s sales, foot traffic and rent collection have performed over the past year and how ongoing pandemic restrictions might impact the property. “It’s not that anybody anticipates that tenant sales are going to be what they were pre-COVID, but if a property is showing positive trends, that’s a great story for someone underwriting a retail asset today,” explained Steeb.

While lenders long have paid close attention to how co-tenancy clauses might impact the performances of malls, they’re applying the same analyses to other property types, including strip and power centers, she said. “Co-tenancy has always been a factor [for lenders], but there’s more emphasis on it today and lenders look to us to provide more details” about the potential impact on a center’s NOI should store closings trigger co-tenancy clauses.

The pandemic also has led many lenders to scrutinize the experience and track record of a property’s ownership or sponsorship and its leasing and management teams. Lenders, said Steeb, want to know a property is in capable hands when it comes to filling vacant space and other critical tasks. “If you don’t have tenant relationships in the retail world, you may have difficulty replacing a tenant that goes dark,” which, in turn, might trigger co-tenancy clauses leading to reduced rent and/or other store closures, explained Steeb.

Many underwriting trends that have emerged or gained traction during the pandemic won’t taper anytime soon, but there’s some evidence that lenders are starting to relax certain requirements.

Steeb said lenders appear to be easing requirements when it comes to debt-service reserves. When the economy ground to a halt last spring, some insisted that borrowers set aside a year’s worth of debt-service reserves, she noted. Today, lenders may require borrowers to have three or six months in reserve, or they may waive such requirements for loans with certain debt-service coverage ratios. “What I’ve seen from lenders is greater flexibility,” said Steeb. “In the beginning [of a crisis] they panic and grab for a lot, but as the market settles down, we’re seeing some relaxing of certain requirements.”

At CIBC US, said commercial real estate president Karen Case, the process of underwriting retail properties continues to rest on certain bedrock principles. “Underwriting for retail — or any asset class, for that matter — continues to focus on realistic and achievable cash flows, credit worthiness of tenants and, most importantly, sponsorship,” she explained. “The process of underwriting has not deviated; we look for the best sponsors focused on the best locations with tenants who fulfill the needs of the community being served.”