As commercial mortgage-backed securities players discussed the outlook for real estate fundamentals and their impact on the CMBS market at last month's Fabozzi conference, one of the themes that was consistently a source of hot debate was the potential impact of e-commerce and the Internet on retail properties within CMBS pools.

Whether investors choose to be concerned or ignore it, most agreed that in the long-term, the retail capabilities of the Internet could present a major challenge to the CMBS market, as electronically-driven sales continues to cut into the business of traditional retail outlets.

"The Internet is going to cause investors to look at any tenant concentration and say to themselves, Is that tenant ripe to be cannibalized by the Internet?," said Joseph Franzetti, a CMBS analyst at Duff & Phelps, a credit rating company. "Will it ultimately impact retail? I think the answer is yes. The question is, how badly does it impact retail and which segments will get hit the worst?"

According to sources, as the Internet becomes a more effective vehicle for retail and trade, experts fear that certain stores will have a large chunk of their profitability taken away - a development that could cause businesses to go dark and threaten the viability of commercial collateral.

An Exaggeration?

There is no doubt that retail properties can have a measurable impact on the performance of CMBS.

Retail was the largest single property type in new CMBS issued last year, and it comprises approximately 30% of the collateral backing all outstanding CMBS, according to a report from Moody's Investors Service written by Sally Gordon, a vice president and senior analyst.

However, while most players agree that profitability will be eroded for some retail operators due to the Internet, they also say electronic retail is not an imminent threat to conventional retail, and it may be far too early to tell what the actual ramifications for CMBS might be.

"I think that the effects are probably exaggerated in some settings and not given enough attention in other settings," said Moody's Gordon. "The problem I have is that I think the Internet will affect some products pretty notably and other products virtually not at all. But if you've got a CMBS with any amount of retail in it - and most have between 20% to 30% of the securities backed by retail space - if there is a different dynamic affecting the performance of those shopping centers, that means your old analysis has missed an important variable that can affect the shopping center."

The problem is particularly acute for "big-box" retailers, Gordon says, because some of that merchandising lends itself to Internet sales very well. Even though many big boxes look generic, if these stores are abandoned, a replacement with the exact same needs and goals is often difficult to find.

Shopping: A Social Activity?

The main problem, Gordon says, is that the Internet does not have to erode very much of retail sales to enormously affect the profitability of a retailer. According to her study, a 7% decline in retail sales will result in a 50% decline in profitability, which Gordon described as "horrendous."

"In my view, the retailers or tenants that will benefit going forward are the ones that figure out a business where they capture the synergy between the bricks and mortar in store sales and electronic sales," Gordon said.

Some investors seem to be taking extreme views on either side of the issue - either that the Inernet will replace shopping centers altogether, or the other extreme, which is that shopping centers are impervious to it completely.

According to Gordon, neither one of these views is realistic. However, many investors and retailers strongly believe that shopping at a mall is a social activity that includes some form of entertainment value, and this can never be replaced by the Internet.

"Nobody knows what the landscape will be down the road," said Stephen L'Heureux, vice president of AEW Capital Management, and a panelist at the Fabozzi conference. "But clearly some commodities are well-suited for the Internet, like books and music. Still, the Internet will be effective for planned expenditures rather than impulse."

Michael Hoeh, a senior portfolio manager at Dreyfus, concurs. "E-commerce may destroy the catalog market. But will it harm Home Depot? I doubt it."

Still, buying on the Internet is compelling: first of all, it is far more convenient. There is no parking, no waiting at cash registers, and browsing the web is certainly easier than visiting multiple stores. For this reason, Gordon says, even a small nibble from retailers' profit could be sufficient to threaten the economic viability of retail tenants, which in turn may threaten the full and timely payment over the term of CMBS bonds.

Lease Structures Might Change

Internet retail, therefore, could selectively affect the future risk profile, volatility and performance of some retail properties. However, some CMBS sources believe that many circumstances have to come into play before the actual mortgage performance of mortgages within CMBS deals are affected.

"I think that we really have to look at things more along the lines of category killers," said Duff & Phelps' Franzetti. "Anything that is a category killer is a commodity, and it is ripe for being exploited by the Internet."

According to Franzetti, those "category killers" have been set up as triple-net-lease transactions, so it is only after the impact of e-trade affects the credit quality of the retailer and their credit goes down that the mortgage performance may get hurt.

Therefore, if a store is closed, it does not necessarily hurt the retailer, as long as their credit is not hurt.

However, Gordon sees changes in lease structures as a more troublesome dilemma. Because leases now capture some percentage of sales, if people see products in a store and then go home to buy it on the Internet, the shopping center owner might request a slice of the total corporate sales, further cutting into profits. - AT

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