If there is one bank loan type that is changing, it is lending to small businesses and retail properties. While the credit of other products ebbs and flows with the business cycle, the complexion of many small business loans and commercial real estate (CRE) loans to retail projects are changing. This means of all the lending categories, underwriters need to pay the most attention to retail. Having a major anchor tenant such as a Sears, Macy’s or a grocery store used to be important to banks both to stabilize credit and to drive traffic to the rest of the tenant base. Now, ironically, banks look for the quality of a food court, gym or restaurant to support both credit and traffic. Tenant analysis has been flipped on its head and is now more important than ever. We will take a look at some of those changes, look at the risk for both metro and rural banks plus highlight ways banks can train their managers, lenders, and underwriters to see more into the future.
Uber and Lyft have dislocated taxi companies, medallion lending, and rental car companies while Airbnb has hurt hospitality. These are clear examples of areas where banks should have been and should be managing their risk. While this trend of retail moving more online has been going on for a while, it is important for bankers to note that the trend is still in its infancy. Despite this notion that retail has undergone this huge transformation, only 9% of total retail sales (as of June) are online. Major changes still lie ahead.
In particular, individual industries face varying degrees of competitive threats from e-commerce. Electronics, has and will continue, to move more online but has largely reached its near-term saturation point. Sporting goods, vehicle motor parts, and even grocery stores have relatively little online cannibalization and represent a material risk for community banks.
Shifting Consumer Preferences and Technology
In addition to managing dislocation because of technology, then there is the risk of changing consumer preferences. Cupcake stores, once a clear money maker, are now starting to struggle due to increased competition and greater alternatives. Juice stores that focus on cleanse, gyms that charge by the hour, stores that specialize in olive oils, panic game rooms and blow dry bars are all undergoing declining profitability.
The Silver Lining
We want to quickly point out that these highlighted risks are not all negative. Technological change and shifting consumer preferences create as many winners as losers. While grocery stores may come under stress, virtual reality gaming centers are on the rise and can also serve to take the space left by the grocery stores. While clothing and specialty food stores might be on the decline other companies will rise up to take their place. Drone repair companies didn’t exist last year and are now a growing category.
Managing The Risk
To mitigate the risk of technological dislocation and changing consumer preferences, banks need to focus on these twin harbingers of defaults. Specifically, this means:
- Borrower Questions: Increasing borrower interview questions around future consumer preferences and the expected extent of future technological disruption. To what extent can your borrower or property owner mitigate this risk?
- Analyst Reports: Leveraging third-party data such as industry analyst predictions and online vs. offline sales trends. At CenterState, for example, we subscribe to several services that track e-commerce trends as well as get on working groups at trade associations that deal with emerging threats or competition. Also, a formal process for disseminating this information is critical so getting management, lenders, and analysts access to this information is important.
- C&I Risk Rating: Train your credit analysts to focus on the threat of dislocation and changing preferences. This means that every analysis should have a mention or rating of the businesses susceptibility to both online disruption and preference shift. Businesses like restaurants are less likely to be disrupted compared to what blockchain could do to title companies.
- Deeper Rent Roll Analysis: It is worth the effort to look at the rent roll through both credit and traffic. We know of one bank that lent on a retail project where the anchor tenant was being converted to a distribution facility. The bank thought this was a no-brainer as the anchor tenant went from being a near-bankrupt company to one with material financial standing. The problem was that the new credit tenant not only brought less traffic but inhibited traffic for the other tenants. The result was that the other tenants were forced out causing problems for the bank. Understanding the risk of disruption for each tenant is now more important than ever from both a credit and traffic standpoint.
- Diversification: Tracking at-risk industries such as pharmacies, department stores, clothing stores and specialty food retailers, both in the credit portfolio and for lease exposure is important in order to manage diversification. Banks that find themselves specializing in certain industries need to devote more resources to monitoring the threat of change.
- Reach a Consensus: Having a consolidated bank view on particular industries is helpful. Specialty food stores, for example, continue to be at risk for both disruption and changing consumer preferences. Having an established view of this risk not only supports better communication but allows marketing to better direct resources (i.e., away from those at-risk industries) and lenders to manage their sales pipeline more efficiently.
The pace of technological change is increasing, and social media promotes ever faster shifts in consumer preferences. Because of the scale that can be achieved in dense urban markets, metro-located community banks are more susceptible than rural banks for these twin risks. However, rural markets continue to be costly to service for small businesses and thus, while shifts will occur more slowly, they will happen.
Banks need to shift their credit gaze more forward to see the sharp turns and dead ends ahead. Understanding what disruption looks like and how it occurs is a relatively new skill for underwriting staff and thus must be trained. Ignore this advice if you want, but understand that doing so, will only serve to increase disruption in our industry.
Submitted by Chris Nichols on October 23, 2017