Concern over the fates of J.C. Penney and Sears Corp. has yet to blow out the spreads of commercial mortgage backed securities (CMBS) with exposure to the department store chains, but in light of their potential bankruptcies investors best be aware of the weakest links.

Spreads on bonds with exposure to J.C. Penney and at the bottom of the CMBS capital stack widened 10 or 15 basis points in the first few weeks of October, when the retailer’s stock price fell to a 13-year low and unsubstantiated tweets suggested it was moving closer to bankruptcy. The market quickly overcame its jitters and spreads have tightened since then, said Alan Todd, U.S. CMBS strategis at BofA Merrill Lynch Global Research. News pertaining to Sears Corp., such as the second quarter’s earnings and revenue shortfalls, has had a similar short-term impact on relevant CMBS.

Todd added that spreads widened on fairly limited selling, but he said that a trickle could turn into a flood should either company file for bankruptcy.

Spreads Could Widen on Uncertainty About Store Closings

“If we get an announcement that J.C. Penney has definitely filed, we’ll see spreads jump out, based on the uncertainty about what the restructuring will look like, whether stores will be closed, what it means for the malls they’re in, and the impact of things like co-tenancy clauses,” Todd said.

When such an announcement will arrive is anybody’s guess. Todd said Bank of America’s equity analyst covering the company forecasts that J.C. Penney will have sufficient cash to carry it through the 2014 holiday season. Others suggest one or both retailers could face fatal hurdles next year and perhaps sooner. Nevertheless, some investors have been paying close attention.

“Over the past couple of years we’ve been very focused on malls that have both Sears and J.C. Penney, and we’ve passed on deals that have had that exposure,” said Marc Peterson, a managing director at Principal Global Investors who is responsible for CMBS. He added that several CMBS deals in 2012 had exposure to regional malls and retailers such as J.C. Penney and Sears, but that’s been less the case so far this year.

Steve Jellinek, vice president at Morningstar Credit Ratings, said that Sears, including its Kmart division, has nearly twice the CMBS exposure as J.C. Penney in terms of square feet that may have to be filled should the company declare bankruptcy and vacate. The firm calculates that 182 CMBS deals have exposure to J.C. Penny, while 255 have exposure to Sears Corp. (Sears and Kmart stores), and 98 have exposure to both.

J.P. Morgan noted in a report published Oct. 4 that there are 68 loans where the two retailers are listed in the top three retailers at a property. “Direct exposure to either J.C. Penney or Sears is typically highest in seasoned deals where there are only a small number of loans remaining, and one is secured by a retail property,” the report stated.

Exposure to Sears, J.C. Penney Highest in Seasoned Deals

The data Morningstar uses to calculate its deal-exposure comes from the CMBS servicers, which do not distinguish when the retailers own the space or they lease or rent it from the shopping center owners that issue the CMBS. The latter can be more problematic for CMBS investors, since those payments are part of the deal’s collateral, and the issuer would be responsible for replacing that revenue stream.  

In strong markets, that replacement could actually be a higher end retailer and so benefit the bond deal, but in weaker markets the issuer may have difficulty finding a replacement or end up bringing in a lower-end retailer, such as a Bon-Ton or Boscov’s, for potentially less income. 

Sears and J.C. Penney typically are one of a shopping center’s anchors; the likelihood of finding a replacement tenant beneficial to bondholders depends in large part on the identity of the mall’s other one-to-three anchors. Retailers such as Lord & Taylors and Macy’s typically indicate stronger shopping centers, increasing the likelihood of drawing a healthy new tenant.

“Malls at the lower end would be those adding grocery stores … doing whatever they can to survive,” Jellinek said.

If Sears or J.C. Penney shut a store that it owns, the impact of their bankruptcies on a CMBS deal backed by loans on nearly properties would be lessened.

“It’s going to be the indirect impact on mall traffic, so the question becomes how big of a draw was the store?” Peterson said

Even Indirect Exposure Could Affect Foot Traffic

That indirect impact may be what investors have to consider for most CMBS properties where Sears or J.C. Penney are tenants. Principal’s real estate division has an extensive commercial lending operation, and the company owns real estate across the country. It has been gathering information from its market experts, and so far it appears that Sears and J.C. Penney own most of the real estate housing their stores. Thus a bankruptcy wouldn’t result in a direct financial hit to the CMBS and instead the issue becomes “how it might impact that end of the mall,” Peterson said.

“If you look at Sears and J.C. Penny compared to Macy’s or some of the other stronger anchors, they’re not going to be the primary draw, although that depends ultimately on the specific property,” Peterson said. “We haven’t seen any situations where losing a J.C. Penney kills the mall.”

Nevertheless, such a closure could noticeably impact a mall’s performance if certain factors are in place. For example, noted Peterson, co-tenancy clauses, which typically apply when two or more anchors go out of business, could result in the mall losing part or all of other tenants’ rent. If other tenants pick up and leave, filling those vacancies could be difficult. And even if their revenue is not collateral in a CMBS deal supporting the mall, the tenants’ departure will likely negatively impact foot traffic and the performance of other retailers whose rents are collateral.

“Another thing to keep in mind is the borrower,” Peterson said, adding that major operators such as General Growth Properties and Simon Property Group typically have more pull to bring in desirable tenants than a local company. “It’s really going to depend the strength of that operator and owner to bring a new tenant.”

Vacancies in Rust Belt Would Be Hardest to Fill

Filling those holes also depends on which other big-box retailers are looking to expand. Mervyn’s department store, which catered to a demographic similar to Sears and J.C. Penney, filed for bankruptcy in 2008. Kohl’s took advantage of the situation and acquired spaces in markets in which it had little or no foothold, converting them to its own brand for a significantly lower cost than opening a new store.
“So one of the first things we try to determine is whether a Kohl’s or a similar retailer is already in the market and might be interested in taking that space,” Peterson said.

Todd said shopping centers located in the middle of the country, the rust belt, are likely to face the greatest challenges in finding replacement anchors, given the lack of economic pick up those markets face and the likelihood those markets are already saturated with at least a couple of malls.

In an Oct. 24 report, Fitch Ratings singled out Riverbirch Corner Shopping Center in Sanford, N.C., as one mall that could have difficulty finding another retailer to take over the large space currently held by J.C. Penney. The mall’s other anchor tenants are Belk and Goody’s.

However, the loan on that shopping center is just $12 million, and represents just 0.3% of a deal that Fitch rates, CGCMT 2007-C6.

Other malls in deals that Fitch rates, such as the Aventura Mall in Miami, Florida, would have less difficulty finding replacement tenants in the event of  a J.C. Penney closure. The loan on that mall is in LBUBS 2007-C7.

Todd said that CMBS with exposure to Sears or J.C. Penney continue to price and that he hasn’t seen any notable market push back since recent concerns have surfaced. If one of them was to declare bankruptcy, “There will be a big fire drill where everyone determines how much exposure they have, liquidity will drop a bit, and then the market will move past it.”

Nevertheless, some CMBS will fair better than others. After the initial reaction, Todd said, the market will have analyzed the credits thoroughly.

“Then we’ll start to see pricing start to tier, with deals with more exposure trading wide and those with less exposure and better locations tiering in, as people become less concerned about their outcome,” Todd said. 

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