Investors in commercial mortgage-backed securities (CMBS) may want to begin analyzing the potential impact of another round of department store closings on regional shopping malls.

September has brought a rash of Sears and affiliate Kmart closings, at least six of which will impact existing CMBS deals, either directly because the stores are a part of collateral backing the deals, or indirectly because the closures will damp mall business.

Rounding up reports from regional newspapers, Trepp reported Sept. 9 that six Sears and Kmarts, both owned by Sears Holding Corp., are set to close in the near future.

They're not expected to be the last

"Sears just reported its 30th quarter of negative [year-over-year] sales since the merger with Kmart in 2005 and has closed over 300 stores since 2010—about 2,000 stores remain,” notes recent BofA Merrill Lynch equity research. “Given the long-term decline in sales, we believe Sears will need to close more stores.”

The next round is likely to take place following the 2014 holiday season, the report states, and a similar fate may await stores run by J.C. Penney, which is often paired with Sears because they frequently anchor regional malls. BofA notes in the report that J.C. Penney’s revenues have fallen to $12 billion from $17 billion, but the company has only closed 33 of its 1,100 stores.

"We believe J.C. Penney will more aggressively close stores in 2015 given its lower sales base,” the report states. 

The closing of the department stores on its own is unlikely to dramatically impact most recent vintage CMBS deals, if the transactions cited by Trepp are any indication, given they typically make up small portions of the revenue streams backing those transactions. Trepp reports the Sears in the Towne West Square Mall in Kansas makes up 27% of the space in the property backing a $48.8 million loan, which represents 4.2% of the MSC 2011-C2 deal. That is a significant chunk, but the others make up about 1% or less.

However some legacy conduit deals have only a small number of loans remaining, and their exposure to Sears, Kmart or J.C. Penney can be significant. BofA cited two examples in research published in July: the Collin Creek Mall and the Mall at Fairfield Commons have exposures of 78% and 76%, respectively. The report also identifies 15 CMBS issued between 2005 and 2008 with more than 10% exposure to the retailers.

More recently issued CMBS have shied away from exposure to those tenants, said Marc Peterson, a managing director at Principal Global Investors who is responsible for CMBS.

“You may see a regional mall in a deal today, but in 2011 and 2012 you would see four or five regional malls in the top 10 loans of a CMBS pool,” Peterson said. “Most of these malls would have had a Sears or Penney in them.”

So far, Peterson said, the department store closings do not appear to have affected the performance of many CMBS deals. “We haven’t seen a lot of good case studies where Sears or J.C. Penney leave a mall,” said Peterson. “A lot will probably play out over the next year, with these most recent closures especially.”

Wall Street generally gives J.C. Penny higher marks for its turn around efforts, and it has had two consecutive quarters of same-store sales and year-over-year margin growth.    

Beyond the fate of individual retailers, there are concerns about the viability of lower-quality malls. “Over the past few years as the income inequality gap has increased, the middle-tier retailers have been one of the more broadly recognized casualties,” BofA noted in its report, saying that national store closings in the mall space in 2014 are expected to exceed store openings by almost three to one. “We believe lower quality malls will suffer the majority of closings and may see occupancy rates slip by year-end.”

BofA defines lower quality as malls with in-line sales, or sales of tenants besides the anchors, as below $350 per square foot, and many if not most regional malls—those outside the major metropolitan areas—fit into that category or are flirting with it.

Besides the slipping buying power of their traditional middle and working class customers, their sales have been eroded by Internet retailers, especially for more commoditized items such as office supplies, books, music and toys.

“What I’ve been advising clients to do is that if you have exposure to any of these assets that are in the bottom performance decile, you probably want to take a good hard look at them,” said Alan Todd, U.S. CMBS strategist at BofA Merill Lynch.

Todd added that Sears and J.C. Penney store closings in stronger malls are not a concern and may even be a boon. If the mall landlord owns or can buy out the property, then it can find a replacement tenant that draws more foot traffic.

In fact, General Growth acquired 11 Sears store sites from Sears Holding in 2012, allocating an estimated $250 million toward the parcel at Ala Moana Center, a high quality mall in Hawaii

“[General Growth] likely viewed the Sears store as not the optimal way to draw shoppers and tenants to the mall and welcomed the redevelopment opportunity, said Tad Philipp, director of commercial real estate research at Moody’s Investor Service.

The opposite may be true at weaker malls.

"We’re worried about the low quality mall located in a low-traffic area that has a Sears—if it goes, that’s just one more nail in the coffin,” Todd said.

Even if the Sears or J.C. Penney is not a part of the collateral backing a CMBS loan, said Joe McBride, a research analyst at Trepp, the closing could reduce foot traffic. In addition, co-tenancy clauses may give other stores the ability to escape their leases, exacerbating the situation.

“The class A trophy malls are still doing pretty well, but there are a lot more secondary and tertiary properties in general, because there are only so many primary locations like New York, Washing D.C. and Miami,” McBride said. “The future of brick-and-mortar retail is anybody’s guess.”

One likely outcome is that many regional malls will disappear.

“If a market has three malls, probably now you only need two,” said Peterson, adding it is important to identify the weakest one in a market, as it is the likeliest to go first.

One indication that a mall may be headed for trouble is stores that clearly need renovation.

“One of the things we look for is whether major stores have recently been renovated ... how retailers are voting with their own cash,” said Phillip. “If a store hasn’t been renovated in awhile, and its lease is expiring in two or three years, it might raise concerns.”

In-line sales capacity is another key indicator, he said, noting that strong malls are in excess of $600 per square foot while those at $300 per square foot and below raise concerns.

Having a Sears or Kmart as a major tenant is unlikely to help on either of those fronts. In mid-September, their privately-held parent company borrowed $400 million from its chief executive’s hedge fund, secured by 25 of the company’s properties, giving the retailer a cash infusion before the holiday. 

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