Driving with the Rearview Mirror
“I am really sorry,” whimpered the teenage driver as he pointed to the crumpled front fender of the car after rear-ending a car in front of him. “I never saw it coming.”
The father was incredulous and asked, “What were you looking at?”
The teen replied, “I was looking at my friends in the car behind me in the rearview mirror.”
I know this is a bit of a silly story, but it seems that sometimes we bankers and other financial types spend most of our time looking in our own rearview mirrors. We look back at historical financial performance and see the future (or something pretending to be the future). We look at specific companies and/or industries and past performance and make assumptions for the future.
For financial institutions that are involved with investment commercial real estate, this could be a particularly dangerous approach. For those who are financing strip malls, multi-use retail spaces or shopping centers the world has been changing rapidly.
2018 saw bankruptcy filings and store closings for such household names as:
- Bon Ton (Herbergers and Younkers; 256 stores)
- K-Mart and Sears (142 stores in 2018 and 80 projected for 2019)
- JC Penny’s (8 in 2018 and 140 in 2017)
The trend continues in 2019 with:
- Chipotle closing 65 locations
- Toys R Us closing 735 stores
- Starbucks closing 150 locations
- H & R Block closing 400
- Shopko closing over 100 stores
Since much of my travel includes smaller towns in Michigan, Wisconsin and Minnesota, several of these names will hit close to home. And many of these “household” names have historically been the anchor for extending real estate financing. When these stores close, it may take a very long time (if ever) to find a new tenant to occupy the space and at a potentially significant cost in terms of new tenant improvements.
In many cases, loan accommodations were made without any financial covenants (bad) or, if there are covenants, they are calculated on historical cash flow (better, but not good). In other cases, the tenor of the lease(s) for the borrower does not coincide with the loan maturity. Banks are extending 5- and 7-year loans when many of the tenants have lease expirations well short of the maturity. In the event of either the bankruptcy of a significant tenant or turnover/vacancy risk from non-renewal, the bank may have no remedies until a payment default has occurred and/or a covenant violation that was really triggered months earlier from other business events.
While covenants are not necessarily going to prevent a liquidation or foreclosure in every case cited above, I am a believer in getting out in front of potential problems at the earliest possible time and working proactively with the borrower to restructure or renegotiate the loan accommodations.
So, what might the lender do to protect themselves and provide an early warning system? Covenants that are proactive in nature can assist. Some examples would include the following:
- Occupancy covenant. An occupancy covenant could be included that would trigger in the event the leased and occupied square footage of the collateral property falls below a certain level for specified number of days (10 to 30 as an example). If this type of covenant is included, it is prudent to include a minimum lease rate per square foot so that high dollar leases are not replaced with lower lease rate tenants.
- Double downgrade. Another possible covenant would be a double downgrade of an investment grade tenant from the credit rating agencies.
- Go dark provision. A third possible covenant may be a “go dark provision” for specified tenants. In this case, an event of default would occur if a specific (in general, major) tenant provides the borrower with notice of non-renewal of their lease assuming the lease ends prior to loan maturity. “Go dark” would also include a tenant that vacates the property during the lease term even if they intend to continue making the lease payments after vacating the property.
- Tenant bankruptcy. Finally, a bankruptcy filing by a specified tenant could also constitute an event of default.
As in the initial story, distracted driving can be dangerous and hazardous to the health and safety of yourself and others. However, when lending professionals neglect to include proactive financial covenants in their borrowing relationships because they were only looking in the rearview mirror, don’t be surprised if you crash into the company or industry that just slammed on the brakes in front of you.
Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.264.9150.