The commercial real-estate market is bracing for a major crisis, and shopping malls are at the center of the storm. Gurnee Mills, a once-thriving outlet mall in Gurnee, Illinois, serves as a stark example of the challenges facing the industry. In 2019, the credit rating agency Fitch Ratings downgraded its outlook for the mall to "negative," citing a rise in vacancies and a decline in cash flow. This downgrade raised concerns about the $1 trillion in debt tied to shopping malls, which could have severe implications for the financial sector.
The current predicament stems from the packaging of mall loans into commercial mortgage-backed securities (CMBS), which are then sold to banks. The loans are divided into slices known as "tranches" and are backed by the malls. However, with the rise of e-commerce and the impact of the pandemic, malls have been struggling to repay their loans. This has created a worrisome situation for banks and pension funds that have invested in mall CMBS.
The International Council of Shopping Centers (ICSC), a trade group, has warned that if tenants are unable to pay rent due to coronavirus restrictions, it could lead to a domino effect that could damage financial markets in the long run. Malls have traditionally served as the primary civic square in many towns, making their potential downfall a significant concern.
The next two years are critical as a wave of mall loans is set to mature. Should shopping mall owners fail to repay their loans, it could trigger a crisis that would force malls to close their doors. This, in turn, would affect banks and pension funds heavily invested in mall CMBS. Although the Treasury and the Federal Reserve have injected substantial amounts of money to prevent a crisis, the mounting pressure on malls due to the pandemic may require further intervention to avoid a disaster akin to the 2008 financial crisis.
The Architecture of the Problem
Gurnee Mills, like many malls across the country, faced closure and empty corridors due to the pandemic. Simon Property Group, the largest mall operator in America and the owner of Gurnee Mills, declined to comment on the situation. The issue extends beyond Gurnee Mills, with approximately $4.6 billion worth of mall CMBS loans set to mature this year and next. Simon Property Group and Brookfield Property Partners account for 65.1% of the outstanding balance of these loans.
The pressing question now is whether mall operators, such as Simon Property Group, will be able to restructure their loans to avoid default. As of March 2020, 31 regional mall CMBS loans, worth about $2.2 billion, were in special servicing. Moody's reported a rise in delinquency rates, with payments less than 30 days late increasing to 8.4% of all CMBS, with the retail sector experiencing the highest delinquency rate.
Professor Clifford Rossi of the University of Maryland's Robert H. Smith School of Business emphasized the importance of loan restructuring to mitigate losses. The ability of the obligor to repay the restructured loan is crucial, as seen during the 2008 financial crisis, where lenders faced significant redefaults on modified residential mortgages. The commercial real estate sector is not immune to similar challenges.
With a total outstanding commercial real estate debt of approximately $3.66 trillion, industry advocates urged the Federal Reserve to include private-label CMBS in the Term Asset-Backed Securities Loan Facility (TALF), a government program created in 2008 to increase liquidity in the securitization markets. In April, the Fed complied, adding commercial mortgages to the list of eligible underlying credit for asset-backed securities.
Despite the bleak outlook, Moody's Associate Managing Director Robb Paltz suggests that malls like Gurnee Mills, owned by companies like Simon and Brookfield, have a better chance of weathering the storm due to their investment in mall updates. However, the aftermath of the pandemic could leave substantial holes in the rent rolls, potentially leading to the demise of many retailers.
The Role of Hedge Funds
Moody's has put mall deals "on watch" due to their exposure to the regional mall market. Hedge funds have taken note of the crisis and are positioning themselves accordingly. By buying credit default swap contracts tied to mall loans, hedge funds stand to profit if malls default on their loans. These investors are essentially betting on the failure of malls and the subsequent drop in CMBS value. Even Goldman Sachs has advised clients to bet against the CMBX-6, a derivatives index tied to CMBS of shopping malls, further fueling concerns.
On the other hand, pension funds and asset managers like PIMCO, Putnam Investments, and AllianceBernstein are betting on mall operators' ability to repay their loans.
The worry is that if malls default, the value of CMBS will plummet, resulting in significant losses for bondholders, banks, and pension funds. This could lead to a freeze in the commercial real estate debt market and hinder liquidity.
Comparisons to the 2008 Crisis
The collapse of mortgage-backed securities in 2008 stemmed from a lack of confidence in underwriting, rating agencies, and the long-term performance of real estate. Unlike subprime mortgages, commercial mortgage defaults were minimal at that time, accounting for only 1.2% compared to 40%. However, investor confidence in debt instruments faltered, causing the loan origination market to slow down drastically.
The Federal Reserve's current goal is to prevent a similar loss of confidence. The challenge lies in the economic conditions that make it difficult for malls and hotels to repay their loans. The ICSC has urged the government to recognize the $1 trillion of debt underlying shopping centers and to revise corporate credit facilities to accommodate borrowers without investment-grade debt.
Mall operators may need to renegotiate loan terms with banks as their tenants struggle to pay rent amidst pandemic-related closures. The lost revenue for tenants translates to lost revenue for mall real estate investment trusts (REITs). Late payments and defaults are expected to rise in the coming months, primarily dependent on the speed of business reopening and consumer apprehension about returning to normal shopping habits.
The Federal Reserve has taken steps to unfreeze markets through asset purchases and credit market facilities. The injection of liquidity into the financial system has surpassed even the levels witnessed in 2008. However, the pandemic has created stress throughout the mall REIT sector, with the future of offline shopping remaining uncertain.
As malls gradually reopen, the critical question is whether shoppers will return in sufficient numbers to sustain retail businesses and keep mall loans current.
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