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CMBS Quarterly Insights: As Outlet Centers Take On Malls, And Each Other, Principal Losses Will Likely Follow

Publication date: 11-Nov-2013 09:01:01 EST

With U.S. retailers desiring to expand into new store locations, and with almost no new mall space being built, outlet center development has prevailed in recent years (see Charts 1 and 2). With increased development activity, markets that were once considered to be off limits for outlet centers due to proximity concerns are witnessing renewed life.

Retailers appear to have lifted radius restrictions, which prevented their outlet stores from locating too close to an existing full-line location. For example, Colliers International estimates that about 64% of Nordstrom Rack stores are located within five miles of a full-line Nordstrom, and 42% are within one mile. At the same time, there have been more instances of outlet centers popping up in competing markets and targeting the same shopper.

As outlet centers continue to invade each other's space, as well as a traditional mall's trade area, we expect there could be operating casualties and principal write-downs in oversaturated retail markets. That is because there are just so many retail slices an existing trade area pie can be cut up into. (Listen to the related podcast titled, "U.S. Outlet Centers Take On Malls, And Each Other," dated Nov. 13, 2013.)

Outlet Centers' Recipe For Growth

Outlet center openings quadrupled to eight in 2012 compared with a rate of two per year in 2009, 2010, and 2011. In 2013, 11 have opened or are scheduled to open by year end. As outlet center owners/borrowers search for financing proceeds, commercial mortgage-backed securities (CMBS) have been playing a role in this growth.

Retail tenants continue to look to participate in the outlet format and capture the shoppers who are searching for value in a struggling economy. Value-starved shoppers who might not be able to afford full-price designer labels have been venturing to the outlets for custom designer outlet product lines.

Developers have found outlet centers to be profitable, largely because of their strong sales levels and low operating costs. In addition, developers like that outlets might be somewhat less sensitive to competition from e-commerce than full-price stores are, as most retailers today are not selling their made-for-outlet goods on the Internet. With strong tenant and shopper demand, developers have been building new centers, expanding existing ones, and converting other retail formats into outlet center properties.

Historically, outlets have not always been the retail segment of choice. About a decade ago, there was industry consolidation, failed operators, and CMBS outlet collateral that was liquidated at significant losses due to cut-off situations. A cut-off event typically occurred when a developer introduced an outlet center that was between a rural-located center and one that was closer to the permanent population. These infill located centers took business away from existing outlet centers because they were new, usually larger, and a shorter drive from major metropolitan areas.

In recent years, however, outlet center performance has been strong. Based on an analysis that we performed using 2006 vintage year (a relatively large year for outlet center originations) outlet and traditional mall center loans from securitization through 2012, outlet center net operating income (NOI) increased by 41% compared with NOI growth of 9% for traditional malls.

Chart 1

Chart 2

Operating Metrics Stimulate Development

Strong operating metrics continue to support new outlet center development, while lackluster mall performance points to very little growth in this segment. According to Value Retail News, U.S. outlet centers are expected to increase to 196 by the end of this year from 185 in 2012. Value Retail News only includes centers with an outlet tenancy of at least 50% by gross leasable area (GLA). The average GLA of an outlet center has increased by 40% to over 383,000 square feet (sq. ft.) at the end of 2012 from about 271,000 sq. ft. in 2009 (see table). Some of the earlier centers had GLAs of only about 20,000 sq. ft. compared with the largest existing non-anchored U.S. outlet center, Woodbury Commons Premium Outlets in Central Valley, N.Y., with 845,000 sq. ft. Over the last five years, the number of retail stores participating in outlet centers has also grown by about 14% to 14,793.

Five-Year Comparison Of U.S. Outlet Centers
2008 2012
Total number of outlet chains 316 322
Total number of outlet stores 12,924 14,793
Average outlet chain size 41 46
Average rent per s.f. ($) 23.00 29.76
Average sales per s.f. ($) 301 357
Average store size (s.f.) 4,702 4,321
Average discount (%) 37 38
Average center GLA s.f. 271,159* 383,066
*2009 average. Source: Value Retail News.

Malls, on the other hand, have seen limited growth over the last five years, with 1,506 centers open in 2009 and 1,515 open as of Sept. 30, 2013, according to the International Council of Shopping Centers (ICSC). Regional/super regional malls, as defined by the ICSC, have at least 400,000 sq. ft. with two or more anchors, an anchor ratio of 50%-70%, and a primary trade area of five miles for regionals mall and extending out to 25 miles for super regional malls.

The two largest outlet center portfolio owners are Simon Property Group Inc. (Simon) and Tanger Factory Outlet Centers Inc. (Tanger). As of June 30, 2013, Tanger is the largest publicly traded stand-alone operator of factory outlet centers and the second-largest owner of outlets after Simon. In the U.S., Tanger has interests in 40 centers (including four held in joint ventures) totaling 12.5 million sq. ft. Simon has 65 premium outlets with 27.3 million sq. ft. and 13 Mill-branded mega-centers with 19.0 million sq. ft., which totals 78 outlet/value centers with 46.3 million sq. ft. as of June 30, 2013.

For this report, Tanger--with its 100% outlet center portfolio--was used as a proxy for the industry, as Value Retail News had less of a reporting history. Tanger's occupancy rate was 98.7% at the end of third-quarter 2013. This compares with a traditional mall occupancy rate of 91.8% for the same period, according to REIS Inc.

As outlet centers are typically one-level projects with surface parking, they usually cost less to build than traditional malls. In addition, outlet centers have low occupancy costs compared with enclosed malls, reflecting most centers' open-air format. Tanger's occupancy cost rate based on June 2013 results was 8.4% compared with a 12%-13% average for mall REITs, according to Greenstreet Advisors.

Outlet center sales productivity has grown more quickly than the mall sector--and with less volatility (see Chart 3). Tanger reported sales per sq. ft. of $384 at the end of second-quarter 2013. This was an increase of about 20% from year-end 2005. Mall sales, which ended June 2013 at $460 sq. ft., experienced an increase of 13% during this same period. During the recessionary period between 2007-2009, outlet center sales declined by less than 1% compared with a decrease of 12% for malls.

Chart 3

To further review operating performance, we also did an analysis of property-level servicer-reported NOI to see how outlet center and mall collateral performed in the recent cycle. Based on this review, and using a representative sample of 2006 vintage year outlet and mall center loans, from securitization through 2012, outlet center NOI increased by 41% compared to mall NOI growth of 9%. During this period, the only year when there was negative NOI growth was 2010, when mall collateral NOI declined by 3% (see Chart 4).

Chart 4

Outlet Centers Compete With Each Other

Outlet centers began as shops attached to manufacturing plants, designed to provide a place where manufacturers could sell their overruns and excess stock directly to the consumer. To take advantage of traffic patterns, manufacturers opened stores that were not directly attached to their factories. Outlet centers started to be developed in rural locations, sometimes as far as 60 miles away from any major metropolitan center. Rural locations enabled manufacturers to take advantage of lower land costs and avoid direct competition with retailers that carry the manufacturer's products.

Manufacturers later adjusted their strategies by being more aggressive in doing business closer to their big retail customers, especially in locations near major metropolitan areas. As a result of this shift, outlet center developers built sites closer to the major cities and areas of permanent population. The development of outlet centers in infill locations impaired the existing outlet centers that had their traffic cut-off by a new and usually larger center.

Today, developers are competitively placing outlet centers within a short distance from each other. We've heard about quite a few battles brewing, including scheduled projects in Chicago; Louisville, Ky.; and Baltimore. Simon's St. Louis Premium Outlets and Taubman's Prestige Outlets have been generating headline news because they are both located in Chesterfield, Mo., they both opened in August, and they are within less than one mile of each other. The two properties have a total of about 800,000 sq. ft.

Outside of these two new outlet entrants in the St. Louis area, there is also more than 6 million of primary/secondary retail/mall GLA that are within an easy drive of each other. Included within these properties is St. Louis Mills. This REO property (now called the St. Louis Outlet Mall), which is in the Morgan Stanley Capital 2007-IQ13 transaction, has a current balance of $79.0 million. An appraisal reduction amount (ARA) of $45.5 million was taken on Oct. 8, 2013. The two new outlet centers mentioned above will likely bring additional competition to the already-hurting St. Louis Outlet Mall.

There are two schools of thought for these newly competing outlet centers. Skeptics believe that the trade area might not be able to support both outlet centers, while others are of the opinion that Chesterfield could become a retail mecca and attract shoppers beyond its typical trade area.

It is our belief that the St. Louis market will likely not be able to support all of this retail. According to the U.S Census, St. Louis City exhibited a population decline of 0.4% from April 1, 2010, to July 1, 2012, while St. Louis County's population increased by 0.1% during the same period. The 2010 census also reported that the population of St. Louis has dropped by 8.3% since 2000 and is at its lowest point in 141 years. With limited population growth and a market that appears to be over-retailed, there could be additional victims.

That's not to say that multiple outlet centers cannot compete in the same market. In some markets, they have a history of coexisting. There are multiple centers that are doing fairly well in Las Vegas, Orlando, and Lancaster, Pa., but those are major tourist destinations and have a captive audience.

Outlet Centers Invade Mall Territory

In addition to the St. Louis Outlet Mall ARA, a more prominent CMBS casualty occurred in Credit Suisse First Boston Mortgage Securities Corp. 2005-C2. The Tri-County mall, which is located in Cincinnati, Ohio, was the first CMBS loan that realized a principal loss and affected an originally rated 'AAA' AJ tranche. In 2009, Cincinnati Premium Outlets opened 14 miles from the mall, which has been under financial distress. The Tri-County Mall was transferred to special servicing in August 2009 and was most likely a casualty of the premium outlet center development.

Because of the profitability of the outlet channel, mall store retail vendors are opening stores in outlet centers. In the past, retail chains typically wanted to make sure that their outlet distribution channels didn't compete directly with their wholesale operations. Many goods now are being produced specifically for outlet centers and are not leftover items or goods damaged or returned at full-price stores at the malls. But as retailers shifted their product mix, they removed one of the major barriers to outlet development: radius restrictions, where vendor conflicts prevented outlet stores from locating too close to an existing regional mall. As a result, outlet centers have invaded trade areas once dominated by malls.

Major department store retailers--such as Nordstrom, Bloomingdales, and Saks--have expanded their outlet store operations as they look to draw a new customer base and expand their multichannel efforts. They seem to have overcome the issue of having their brands sold in locations in the immediate vicinity of where they have full-priced stores. The argument has been made that full-price stores and outlets draw different customers. However, there is also the view that outlet center stores could siphon sales from the full-service department store.

One example of these opposing views is from the Gallery At Westbury Plaza (900 Old Country Road), a value-oriented center in Long Island, N.Y. The property, which is in lease-up, is within walking distance of the Roosevelt Field Mall (630 Old Country Road) and has a strong department store outlet presence, including Bloomingdale's The Outlet Store, Nordstrom Rack, and Saks Fifth Avenue OFF 5th. The Roosevelt Mall property has a Bloomingdale's and a Nordstrom's. In addition, both centers have outlet and full-service versions of several stores, including Banana Republic, The Gap, and Lane Bryant.

Nordstrom Rack and Saks Fifth Avenue OFF 5th relocated from the nearby Source Mall (1504 Old Country Road) to the Gallery. The Source Mall, which is in the Commercial Mortgage Asset Trust 1999-C1 transaction, is REO with a balance of $124.0 million. In October 2013, an $87.4 million ARA was taken. The Source ran into problems when it lost several major tenants, including Fortunoff's, Circuit City, and Steve and Barry's.

In this market, as opposed to the St. Louis and Cincinnati examples, it is our view that both the Roosevelt Field Mall and The Gallery can coexist, as Old Country Road is a highly dense residential area and an established retail destination.

Tenant and shopper demand, however, will ultimately determine whether multiple retail centers can peacefully coexist within the same trade area.

Primary Credit Analyst:Larry Kay, New York (1) 212-438-2504;
Secondary Contacts:Jason J Lami, New York (1) 212-438-6519;
Tamara A Hoffman, New York (1) 212-438-3365;
CMBS Surveillance:Barbara A Hoeltz, New York (1) 212-438-3621;
CMBS:Peter J Eastham, New York (1) 212-438-5908;
Investor Relations:Ted J Burbage, New York (1) 212-438-2684;
Ernestine Warner, New York (1) 212-438-2633;

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