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.
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.
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.

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.

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
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.
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.
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