Borrowers Flee Empty Malls and Bond Investors Brace for Fallout

(Bloomberg) -- Things are getting worse for malls across America. So much worse that their owners are walking away early from struggling properties, a trend that has mortgage bond investors bracing for losses.

Mall operators, eyeing defaults caused or made more likely by shuttered stores such as Sears Holdings Corp., are handing over their keys to lenders even before leases end. That’s forcing loan servicing companies to either take a shot at running the properties or sell them cheap. And if they’re unable to salvage the debt payments, investors in commercial mortgage-backed securities will take a hit.

Borrowers Flee Empty Malls and Bond Investors Brace for Fallout

The number of mall loans issued since the financial crisis identified as “highest risk” has almost tripled to 29 this year, according to Wells Fargo & Co.

Last month, Washington Prime Group, a REIT, said it gave up on two malls in Kansas whose loans had either defaulted or were headed for default, according to Deutsche Bank AG. And this month, Pennsylvania REIT announced it fled a mall in Wilkes Barre that had a loan headed for default, and it may abandon another in La Crosse, Wisconsin for the same reason.

“Experienced borrowers will act in their economic interest and will turn in the keys to malls that don’t merit further investment. They don’t want to service the loan anymore,” Edward Reardon, head of CMBS research at Deutsche Bank, said in a phone interview. “We think the number of malls that don’t merit investment will expand.”

This is happening because malls are losing anchor stores and as a result would have to significantly cut rents for existing occupants, Reardon said, noting that mall owners fleeing their properties early is a “relatively new phenomenon.”

That may mean trouble ahead for investors. While the delinquency rate in the CMBS market is now at post-crisis lows, the mall-related pain may not show up for a couple years, according to analysts. That’s because the securities with the highest exposure have loans that won’t mature until 2021 or later.

While many mall loans since the financial crisis got scooped up into CMBS and several of those debts are now at risk, very few are being bundled into new securities anymore because of the concerns about defaults.

Borrowers Flee Empty Malls and Bond Investors Brace for Fallout

So-called co-tenancy clauses for smaller mall tenants have helped hasten the trend. While each clause is different, they generally say that if the mall doesn’t have a certain number of anchors, the tenant can terminate its lease. For instance, as Sears closed stores following its bankruptcy, the contracts allowed others to leave.

That doesn’t mean these beleaguered malls are dead. The door is still open for investors to swoop in and snatch them up on the cheap.

Take the Galleria at Pittsburgh Mills, a mall 15 miles (24 kilometers) northeast of its namesake city. The mall’s mortgage, which pegged the center’s value at $190 million in 2006, was packaged into a CMBS pool. It eventually fell into default, with the borrower failing to pay more than $100 million in loan principal, according to data compiled by Bloomberg. Great Neck, New York-based Namdar Realty Group and Mason Asset Management bought the property for $11.35 million earlier this year. The mall remains open.

It’s an extreme example that illustrates why the CMBS market is reticent about buying up mall loans, even as many shopping centers across the country are performing well.

“We talk about these malls all day long,” said Ben Easterlin, head of commercial lending at Atlanta-based Angel Oak Companies. “We have not seen any of these malls in a CMBS lately and don’t expect to, frankly.”

But his firm is open to financing them if the numbers make sense. Easterlin said he’s “kickin’ the tires” on lower-grade shopping centers away from major metro areas, ones that are still solid, well-positioned properties, but won’t find an outlet in the CMBS world in part because “it’s easier to value a mall in L.A. than it is in Sheboygan.”

Pacific Retail Capital Partners, an investment firm that specializes in buying and operating malls near major metro areas with strong sales figures, manages more than $1 billion of retail assets. But this year it has seized on the increasing number of mall defaults by getting into the business of special servicing, or managing distressed properties on behalf of mortgage bondholders.

A default doesn’t necessarily mean a mall lacks merit, said Steve Plenge, managing principal of Pacific Retail -- it could’ve just been mismanaged. So far, Plenge’s firm has taken over the reins of at least two shopping centers that have been returned to lenders after defaults, and he expects the number to grow.

“We think this sector, the servicing business, will get bigger for us,” Plenge said. “There will be more defaults, more foreclosures.”

©2018 Bloomberg L.P.