Finance Roundtable

Experts share their ideas on trends in retail finance — and the trajectory
of the industry in a slowing economy.

During the Mortgage Bankers Association of America Convention (MBA) in San Diego, Calif., in early February, SCW’s editor Elise Vachon, moderated a roundtable panel featuring some of the finance industry’s top experts.

During that discussion, these accomplished financiers, graciously shared their views on the Unites States being over-retailed, the reasons why, the slowing economy, the recirculation of excess inventory and positive emerging trends.

Attendees:

— Elise Vachon, Editor, Shopping Center World

— Clay M. Sublett, Senior Vice President — Lending, Key Commercial Mortgage

— Shawn P. Seale, Senior Vice President Chief Financial Officer, Capital Lease Funding

— Tom A. Hantges, CFA, USA

— John Davis, Group Publisher Real Estate Group Intertec Publishing

— David L. Reavis, Lead Specialist-Communications, KeyCorp

— Kevin J. Burkhalter, Senior Vice President Johnson Capital Group, Inc.

—James M. Fitzpatrick, Director, Deutsche Bank

— Robert A. Verrone, Director Commercial Real Estate Finance, First Union

VACHON: I'd like to welcome you all to the finance round table. Thank you for agreeing to participate. I'd like to present the topics you selected. However, I'd like the discussion to flow freely, we don't have to stick to my agenda. Let’s begin by going around the table and introducing ourselves.

VERRONE: My name is Robert Verrone, and I am a manager director of First Union, responsible, myself and Chuck Walter responsible for the day-to-day running of the conduit. We just basically close loans, on the right to close loans, securitizing.

SUBLETT: Clay Sublett, Key Commercial Mortgage. I am the chief underwriter in the conduit; D.J. Burke and I run the conduit as far as approval, securitization, and we service our loans as well.

REAVIS: My name is Dave Reavis, and I am also with Key Commercial Real Estate, and I am the public relations/communications specialist.

FITZPATRICK: I am Jim Fitzpatrick from Deutsche Bank. I am in the large loan group, and basically my job is a loan originator, again for securitization.

SEALE: I am Shawn Seale, Capital Lease Funding. I am the CFO there, and we are credit lease originators and underwriters.

HANTGES: Tom Hantges with USA Capital. We are a bridge lender to the four property types of primarily in the southwest USA.

BURKHALTER: I am Kevin Burkhalter with the Century City office of Johnson Capital Group, and we are an intermediary that is arranging really all forms of capital from permanent debt, mezzanine equity, with seven offices in the West Coast. And I think given the line up here, I'll probably speak more toward the insurance pension fund side, since we have the conduit and banking side covered pretty well, which is really one of my specialties.

VACHON: Thank you. Well, I guess the first topic of discussion that I'll throw out there is — and these were collected from all of the participants — the current economy and retail finance and where everybody thinks this is going and the state at the moment.

FITZPATRICK: On the economy in general?

VACHON: And retail finance.

FITZPATRICK: I think you should start big and move down specific. We have all seen statistics in what's going on in terms of jobs and interest rates, and they seem to be surprisingly good, even though they may be moving in sort of even more concerned issues in terms of maybe getting a little more conservative for everything. And I think to go to specific, how does that effect retail and how do you underwrite. And I think it's the point that I keep thinking about and we keep thinking about, is it's easy right now to paint that sector with a big black brush and say stay away. Retail is in trouble or will get worse or something like that. I think it's interesting that it's probably an opportunity, in a lot of different ways, both if you are buying it or just willing to paint the loans, either one. You can really pick your spots and probably make a little bit more money than you are used to, because I think cap rates are moving out in general and maybe not warrant all cases and all situations.

SUBLETT: I guess I would comment that the retail sector as far as finance is our largest concern as far as the major food groups. And we are seeing the obvious shrinkage as far as the big box issues. I am very concerned about the ripple effect. That it's going to impact the overall stability of markets when there is product coming on — I say product — when there is inventory in terms of vacant buildings or buildings that are becoming vacant, what that's going to do to the overall market, in that there are only a finite number of users for some of these boxes and how long is it going to take to fill them and at what rental rate.

And with the expansion that we have seen in retail in the last few years, a lot of discussion that we have is if that space becomes vacant, who is going to take it and how long is it going to stay vacant.

VERRONE: I think I agree with both Jim and Clay in terms of their analysis. You have got to pick your spots, and if you know the operator well, and you like his plan and there is a lot of credibility in that, you like the location, like the tenants, that’s fine. But I don't think this is a big time to take huge bets in retail.

BURKHALTER: There is a lot of talk about the U.S. being over retailed, and there definitely is excess inventory that is going to have to be recirculated, either the building improvements or in some cases just the land that is going to have to be recirculated. Let's say we are in a zero growth economic mode right now, and that's going to translate to weaker sales and weaker profits and weaker balance sheets. We have seen some trends in credit down grades by quite a few retailers, and if you translate that all way down the ripple effect, we are starting to see with insurance companies and even some of the conduits we work with, there has been some upper pressure in credit losses and how they are underwriting the retailers.

And people are picking their spots. In some cases, for example, here in Southern California, you get back to cap rates, when you get into the open-air retail projects, grocery-anchored, it's almost a tale of two cities. There are some centers that we are still providing purchase money financing, and they are selling in the low cap rate range. And then there is kind of everything else that is a second tier. And there is a noticeable gap there in cap rates that we are seeing.

We are seeing a fairly sizeable difference in interest by the capital sources between the first-tier and the first-tier grocery, drug-anchored centers and then everything else. But I think there is a lot of arbitrage. There are some good opportunities out there for people who can fill those niches when there is this broad brush, it's over retailed, and there is just this generality. There are going to be some very interesting niche players that are going to fill that void. It's going to be neat to see that this year.

DAVIS: One thing that's interesting to me is about 12 months, 15 months ago we had these panels, and every topic was E-commerce. It's just interesting. It doesn't seem to be as top of mind as it was at that time. It's obviously still a factor. Another major trend over the past couple of years has been the entertainment centers. There was a time in our magazine where we used to joke, every single press release, every single center was an entertainment center in some shape or form. Any thoughts on that particular sector of the industry?

BURKHALTER: That's a major issue. We just closed a $45 million permanent loan on a grocery, drug, bookstore, theater-anchored center, and two weeks after we rate locked the deal, the theater filed for bankruptcy. And I swear we didn't know anything about it. And at that point — this was in August of last year — it wasn't if someone is going to file bankruptcy, it's who is going to file bankruptcy next week and who is going to file bankruptcy the week after. And I learned a little bit more about the theater industry than I ever wanted to know in that transaction. Fortunately, the advice I give to the developer is just thou shalt only ground lease to theaters. That's the best advice I can give, because that really saved the bacon on this deal, was the fact that it was a ground lease.

We actually had to go back out to the market and prove to this lender that the credit enhancement that they were proposing was overly stiff. And to their credit, it was a knee-jerk reaction. There was a pension fund I pulled out of a purchase of a major mall for the same reason. It actually happened to have the same theater operator that went bankrupt. So it was kind of an unfortunate chain of events. That is going to be a real challenge, I think, for retail developers going forward is how are they going to anchor these entertainment centers. I'm not sure what their replacement concept is going to be and what's going to happen to slope-floor theaters, the old theater chain. It's going to be very difficult recycling that.

I think that's going to be one of the biggest challenges in the recycling of real estate. Bookstores are certainly viable, but the bookstores like the entertainment. They like the theater next to them. So maybe that's another opportunity.

VERRONE: Did you get a lender to close that loan on?

BURKHALTER: Yes. We did close the loan,. Actually First Union had a good quote.

VERRONE: Pre-bankruptcy.

BURKHALTER: Yes. You guys said it was no problem. I think at the time it was maybe a little bit large for Deutsche.

FITZPATRICK: If it was a conduit, that would have been over the cusp. We segregate by size of the loan.

BURKHALTER: Yes, and you weren't alone in that. There were other conduits there.

FITZPATRICK: The theater is a good example of how do you get around that one. And again it goes back to what I keep thinking about: where is it, what kind of location, how many screens? If you go way back on theaters, it's kind of specific, but they used to be almost a cartel, and they wouldn't put more screens in certain areas. You used to look at these maps in our conference room and say, this is where they'll be, and there will be one here. Then that went away, and now they are popping them up left and right.

BURKHALTER: They threw up this radius, I think some of the better practiced soft goods retailers still try to enforce.

FITZPATRICK: It's a tougher underwriting scenario. We have been very tough on theaters in our underwriting, maybe oversized, maybe over conservative. But they have a ripple effect, particularly in the entertainment-oriented centers. We just had one in one where we had already closed the loan, and they filed during the process, and they went back actually reaffirming their lease, and it's going to be okay. But the lease dramatically changed through payments.

SUBLETT: And are you going to try and securitize that loan?

FITZPATRICK: Oh, absolutely.

SUBLETT: And what do you anticipate the response will be?

FITZPATRICK: I think hopefully we picked a spot with a good store behind it investors will like. I mean, that's what we try to do. It's interesting, because I have changed my career from a portfolio lender to a secured type lender. If you close loans that the investors don't like, your long form is forever. That's not our mandate. So you have got to be very conscious of that.

SUBLETT: It's a little bit of a leading question because I can tell you firsthand. I have got a loan down in Florida on a retail center with a movie theater that's 38% of the revenue, not huge, 38%. Bottom line is BP's buyer is saying, if that property won't provide a 1.0:1 debt service coverage without that movie theater, it's out. And that's the approach that we find the bond buyers were taking.

Therefore, that's the approach that we are taking. If we have got someone that is on the undesirable list, a high risk of bankruptcy or store closures, the deal has got to underwrite with at least a 1.0:1 without them, or we are not going to take the risk. Right now the feeling is you are taking a calculated risk if you are playing in an arena with somebody when you know there’s shrinkage. And when in doubt, stay away from them until they stabilize. Lenders are just as conservative like I am.

VERRONE: I think fitness centers kind of fall in the same category. The worst thing is when someone sends you like a retail center anchor, a Regal Cinema on one side and a 24-Hour Fitness on the other, it's tough. We almost zero them out again. We don't give much credence to them.

DAVIS: There has been a lot of talk about the supply of the movie theaters. Was there a demand part of this equation too? Wasn't it a horrible summer? I agree we have more screens than we need to.

BURKHALTER: Yes. One of the problems for the theater exhibitors or movie exhibitors was there really were very few block buster movies last year, and it did affect their sales. And it's kind of a shame that they did over bill, because from financing a lot of retail every year, first it was dot.com retail, online, online, then it moved to clicks and bricks which is probably a pretty good combination we see. Barnes and Noble, I think, is a classic example of what I think will be a very successful click and brick retailer. But you get into a commodisized soft goods retailer, that's who is most vulnerable. The entertainment centers are probably least vulnerable to Internet commerce, but the theater is just such an important thing The theater that is in your center, Jim, was it stadium seating or was it ...

FITZPATRICK: Absolutely.

BURKHALTER: Okay. That's going to help you.

FITZPATRICK: I didn't know this until I started looking into this, but the people will drive past a conventional theater to go to a stadium. I actually confess I have not even been in one because they are not in my neighborhood yet. I'm sure they will be. But that is an interesting ramification. It's a little bit more tricky underwriter question too.

BURKHALTER: To close this loan where the theater went bankrupt, we actually had to go back out in the market. We thought we did our traditional radius demographics and the competition of other anchored centers, we had to go back out and do some primary research about radius for all the different theaters. And we really put them in two categories: Stadium and non-stadium. We found out that we had no competition as far as stadium seating within a two- or three-mile radius. And that really helped. This was a portfolio lender, but if it was someone who was going to sell the loan, I think that certainly would have helped their argument when the BP's buyers were going to give them a hard time. We did the research even before the loan could be committed. And fortunately there was not a radius issue.

FITZPATRICK: Sure.

BURKHALTER: I don't think the theaters practice that discipline.

SUBLETT: I don't know — I mean, if it was securitized — you can argue and you can argue and you can build your data, but I think you are going to lose. The BP's buyers are so controlling the market on the securitized lending side that the general approach nowadays is, we have so many bullets, and there are deals that you may have all the data stacked up, but if it fits a profile, they are going to use that opportunity to kick it out.

VERRONE: We are stuck. We have a loan from 1998, a Regal, 20 million bucks, 98% LTV, 20-year loan, 1.0 coverage. That's the worst of the worst. We are very conservative when it comes to that and have been for six months.

BURKHALTER: Robert, when you said 1.0:1 coverage, were you underwriting them as a credit deal?

VERRONE: As a CTL, yes.

SEALE: Exactly. That's one of the misnomers in the market. You can always talk about credit tenant. Fortunately, the first part of that is credit, and clearly Regal was never there. I mean, the sector got themselves in the trouble, right? You can have either operating problems or just financial bad balance sheets, and they all essentially grew themselves from a competition standpoint. They grew and ended up in bad capital structures that they are now all having to pay the price for. So I think you'll see a shake out. But it's almost to the point that if you don't file as a theater, it's a bad strategic move, because it's an opportunity now.

It's almost expected in the industry. It's an opportunity to get yourself out of the weight of some of this excess debt. And after that's done, then the strong operators will continue, and there will be important strategic assets, just like they are for the bookstores.

BURKHALTER: I think we are already starting to see some healing. I think someone like Philip Anchust is buying UA and other chains and consolidating and recapitalizing those companies. I mean, the bargain basement, cents on the dollar, whatever the right discount, I think the sooner those discounts are marked, probably the sooner the industry can move on. And you are right. I can't tell you how many developers have told me that not filing bankruptcy is almost a hindrance because they can't shed their poor inventory.

SEALE: Get the problem behind them.

BURKHALTER: Uh-huh.

SUBLETT: Shawn, on the topic of credit, what is your perspective on what is, has to be to meet your all criteria? Is it investment grade?

SEALE: Yes. We have always approached the business from a primarily investment grade standpoint. There are generally some tenants that are in the below investment grade category that you sort of like their story. Kroger was an example a few years ago before they were upgraded. They were dominant, the No. 1 and No. 2 grocer in the United States. Clearly, and the bonds traded, frankly, like strong BBB, even though when they were below investment grade. So you sort of looked to the market to let them tell you what the credit is doing, much more so than what the rating agencies are telling you the credit/debt is. But totally from our perspective, we are making 20-year credit bets, and we just think it's inappropriate for the weaker credit, certainly anything down below BB kind of territory to be termed credit.

It doesn't mean you can't ... obviously they can still be very fine retail credits in the center and can be underwritten appropriately. But to really rely on just that income stream for the credit tenant for 20 years, you need to have a strong credit there.

SUBLETT: Do you get into forecasting at all from a potential down grade? With what we have seen in the last few months, are you staying away from some that you think are higher than what you should be doing?

SEALE: Sure. I mean, you mentioned Eckerds earlier. Clearly it's an example of what letting the market tell you what's going, right? And you look at J.C. Penney’s corporate debt. They do not trade like an investment grade credit. So we stopped underwriting that group more than a year ago.

BURKHALTER: Shawn, do you pay attention to the Standards and Poors or Moody's? Let's say; take somebody like J.C. Penney. Are they BBB still?

SEALE: BBB minus, I think.

BURKHALTER: BBB minus. Probably a negative outlook, I imagine?

SEALE: I think so, yes.

BURKHALTER: Do you pay attention to those outlooks by ratings?

SEALE: Yes, definitely. And the rating agencies will tell you it's either on watch or on outlook, if one is more severe than the other is. If you just have a credit watch going, you can either be affirmed, which we saw recently with Windex C, or it can then get put on credit watch which typically means it's a fait accompli.

BURKHALTER: If they assign a negative outlook?

SEALE: No. If it goes on watch, you can almost count on the fact that the downgrade is coming within six months. A negative outlook can be one way or the other. There can be uncertainty about a capital event in terms of with respect to acquisition. You occasionally see companies that do a debt acquisition. They say they are going to then follow that with an equity offering to help shore up the capital structure. That can put a company on watch until they get the equity offering complete. So we certainly pay attention to that.

BURKHALTER: I remember Rite Aid before Rite Aid was downgraded, there were a quite a few lenders that just said we are full up on it, which is in some cases just a polite way of saying the jury is out right now. They may still be investment grade. That seems like a long time ago that they were investment grade, but we really saw a lot pull back on Rite Aid.

SEALE: Yes. It didn't happen quickly enough with Right Aid, simply because it was so much of an unexpected event from the accounting problems that they had. But the market is quick to learn, right? And the next sort of trouble that we saw was with Eckerds, even though it was much less distressful from an actual financial standpoint, the market really shut down in terms of looking at them as a credit. You can still finance them clearly as a good real estate project if you like the property.

BURKHALTER: Were you starting to see widening in spreads on their debentures as they traded?

SEALE: Yes.

BURKHALTER: I mean, it was the quantity of the market telling you that on the pricing?

SEALE: Again I think the rating agencies do a good job on telling us what they think is going on, but the market is much more quick to react from a bond pricing standpoint or an equity standpoint. We really monitor both equity performance and debt performance for the companies that we finance.

BURKHALTER: I think that's the great thing about the discipline on the conduit side. There is real money at risk, because the market, I think, adjusts very quickly. It's nothing like it sounds. It's a little different than the savings and loan and the FSLIC days.

FITZPATRICK: All of us in the loan origination side, you have got to watch that. I mean, there is the real estate at risk, but then the investors would be buying the securities we create. And the cliff is deep if you go from investment grade to BB. And if you are behind that one on some of these tenants, you get priced so poorly. I mean, forget the BB's side. Now you are talking about investment grade, now you are trying to sell. Those are now affected, and that is absolutely critical.

SEALE: The really telling thing, I think, is there is a credit cliffing, and the default rates for investment grade credits over 10 to 15 years is low single digits, and I think under 4 or 5% for even BBB. BB is probably 15 to 20. But those are still much better default rates than you are going to see with non-national credits. Clearly, the real estate business has always been one of tenanting and releasing when you need to, and you have a much better shot of not having to go through that recycling process if you have got an even BB credit. But at some point the real estate really overwhelms the credit decision, and it becomes more of a real estate loan.

SUBLETT: I am thinking about Office Depot, and how many stores that Office Depot announced they are closing. Office Depot is still, what, BBB? And I am going to be hard-pressed to securitize a dark Office Depot.

SEALE: Sure. And the interesting thing is that while you hold the loan, right, as long as Office Depot doesn't file BK, you are going to have a performing loan, because assuming that you have got a net lease from them for a long term, they are going to just continue to pay their rent. You almost worry more about, if it's not a standalone Office Depot, the ripple effect of having a dark property on the rest of your center, which is another sort of anomaly we see that people worry sometimes about; single-tenant risks and doing single-tenant financing. But with a credit-anchored center, you don't have less single-tenant risk, you have more single-tenant risk. Because if the tenant goes down, you have not only underwritten that cash flow, but also some cash flow from the rest of the space which is likely to disappear, and then you don't have the security of a lease to keep you happy.

BURKHALTER: That's what we went through on this theater deal. It wasn't just the theater. It was the fallout with all the restaurants and all the satellites that were supported by them. And they really looked at the traffic very closely. I think one of the questions that Elise put down here was sales and how the economy was going to effect it. The lender went through a very detailed analysis of what is the occupancy cost for those satellites that are supported by the theater, and can they make it, are they making it already or not. And we have seen some lenders that will — let's say there is something high like a 20% occupancy cost. They will discount those rents.

HANTGES: That's why the market has, when it's moved away from grocery anchored to entertainment, gone into more of a market that is less reliant on staples. And that's why today people like grocery anchored, because if it's anchored by a grocery store, it is going to get used, and it's not going to go away because the economy slows down.

We are a bridge lender, and these are the times where we started our company in loaning in the market that was under served by traditional lenders for one reason or another. And this really, the retail environment right now really loans a big opportunity to us to make good bridge loans to quality borrowers and quality projects that potentially can't fit into the conduit programs today for one reason or another. But you know you have a borrower that has the financial wherewithal to keep their property regardless of whether it's debt service at 1.0:1 or .9 , or whatever it may be. They are not going to lose their property.

You simply make some of these judgments obviously. You could never be certain, but you make these judgments just based on who the borrower is and how long they have been around and what their resume says about them and some of the other issues about their personal financial statements.

So we are very excited because we have a very large allocation this year, close to $400 million for bridge loans, and we have started doing some different things to fill some niches. We have gotten into timeshare financing as a result of Finova basically exiting the market. We know that market, and so we have made some very nice loans to the timeshare industry. And now we are getting very interested in the retail sector, because again we are seeing otherwise what would have been loans that we would not have seen.

Incidentally, in Las Vegas, the Desert Passage, which is hooked in with the Aladdin Hotel, it was just built, somewhat of a takeoff of the Forum which is next door to Caesars is having a great degree of difficulty. And one of the reasons I think they allude to is not any great anchors, No. 1 ; and, No. 2 , the fact that the Forum, which was a lot of upscale shops, was built next to Caesars, and you have got a lot of upscale folks. The Desert Passage built next to the Aladdin which basically caters more to a middle market type clientele, they are not really getting the sales per foot.

SUBLETT: Tom, as an interim lender, opportunity lender, do you have a concern that you are lending into a declining or deteriorating market as it relates to retail? And that if it is on the down side, now is not the time to get in. The thought would be wait until it bottoms out. And do you see further shake out?

HANTGES: That's an interesting question. Typically on short-term loans you are making decisions on individuals or on their capacity to hold their properties if they in fact wind up with some short-term difficulties. If you know your markets, you know your location areas, you know what's a good corner as opposed to an area that may not be as prime. I can't judge some of the loans that we are looking at today.

The ripple effect is what worries me more than anything else. What was just alluded to is if one anchor closes, what happens to the rest of the center. Those are the issues that really concern me more, and those are the things that we try to look at. We try to look at who in the center is there. That's why we too like grocery anchored. We try to get in there at 65, to 90% loan to value. But we also try, if it's a good borrower, to try to get some additional collateral. So one way or the other we can help that borrower solve a problem, but we could also get secured.

When you do conduits, obviously additional collateral is somewhat of an irrelevant issue. So you have to make your underwriting decision based on the property, but we can make our underwriting decision based on the resume of that borrower.

Has that borrower been doing this for years? Does that borrower have other assets? Is that borrower going to hold his property? And can we get some additional collateral? So we are potentially a big help to a borrower as long as we feel this person that we are going to loan to is in fact a player that is going to try to hold their property. Then the only issue for us is whether or not this property's problem is just too large. Again that ripple effect. We have all seen them. When one goes and the second, the third, the fourth, the next thing you know you have got a real problem on your hands. That's what we really, really look at.

DAVIS: Tom, are these repositioning, or are these new constructions?

HANTGES: We are doing both. In fact, we have made a couple of loans to Triple Five in Las Vegas. Triple Five have built some nice projects in Las Vegas. Obviously a couple of them have been entertainment centers with movie theaters, and I imagine the jury is out on those, although we are not in those deals any longer.

But for example, a prime piece of property in Las Vegas, 140 acres pretty much in the center of the city just east of Summerland, and with the new freeway that was built in Las Vegas opened up to the property. So the property is a real prime piece of real estate now. We are inclined today to look at that project and give them a phase one development loan, development construction loan to go in there and to start building it, because there is obviously a big need in that particular area.

We will do construction, and we will do bridge. We will do some bridge loans. To date we have been very fortunate, we are very opportunistic, but we really get collateralized not only on the property but also by personal guarantees, by additional collateral. Our feeling is we are only putting out 400 million. We are not doing 5 billion or 50 billion. We don't need to, it's a not a commodity for us. It's more of an individual decision. And we have the time, because we don't do that much, to really sit down and analyze who it is we are doing business with, their resume, their net worth.

FITZPATRICK: It's interesting, because your underwriting is, I would say, very different than what we do. By the time we are getting involved these things are usually built and they are up, and more often than not we have to have an operating history to make a decision. We again are securitized lending.

We are driven a lot by what the rating agencies think. And without trailing 12 and more, it's very hard to get anything out of them that's positive. It's interesting to see, too, that still the best constant that they get out of the rating, we all get out of the rating agency, is the lines you mentioned, neighborhood, grocery anchor are still great. Regional malls still get them. And I think if you go back into the early '90s when real estate really got into bad trouble, those asset classes performed pretty well for the reasons you mentioned.

It's interesting now when you are doing underwriting of existing product that's out there, you might not have seen that product in '92, and how is it going to do. It's funny, one thing that I think we both do is look at the person who is actually developing it — absolutely critical. I mean, the guys who are new, haven't been through that cycle, we try to stay away from them. We like those guys; 15 years is a great number, or 25. You have got to know the guy's seen it. He's been through it. He's not going to pick a stupid location. He's not going to put in bad tenants.

HANTGES: Well, you have seen a lot of store closings today. You haven't seen this many since the early '90s, as you say. So it's something that you really do need to watch. And that's why we also get better rates. Even though, since we started in '89, we have not lost any dollars on long loans. We feel it's a people judgment. It's sitting down and analyzing the person you do business with. An attorney told me a long time ago that good paper doesn't solve bad people and bad partners and those types of problems. If you have somebody who is a real player, a winner, a good track record, that's where you are making your bet.

FITZPATRICK: I would bet you go see every site, too.

HANTGES: Oh, you have to.

FITZPATRICK: That's one of the things that kind of amazes me. I came from the buy side. Before I did what I do today, I would ask originators, did you go see this? They would say, we are going to go see it soon. That's a guy in real estate. You have got to see places — who knows what's across the street. I bet you see everything. We do. Everything we do, on the conduit side, large loans, we are going to see it.

BURKHALTER: You have to with the retail because the quality of the location is key. That's why I think we are going to see a lot more rehab, hopefully not as much new construction in Los Angeles County, particularly because we already have our retail base, and the average age of the standing inventory is relatively old. And the good sites will have equity and debt cap. The secondary sites I think will have to be recycled into something else.

One interesting phenomenon we saw in Los Angeles, in the early to mid '90s, as office rents were so weak, we saw quite a few very dense locations, sites recycled from proposed office developments into high-end retail, and some of it was even single-story.

I think we'll see the pendulum going in the other direction in the future. Anyone here have experience with what I call the main street retail? Just go down Broadway here in the Gaslamp district. Has anyone financed much in the main street retail where, again there is some dependence on the theaters and bookstores? With ground floor retail and then loft apartments?

FITZPATRICK: Unanchored?

BURKHALTER: Usually — yes, often unanchored.

FITZPATRICK: You have got to be careful, in my opinion. It depends on where it is. And again go see it. See who the developer is. So many of the downtowns suffer from not being a regional mall. You go some places where I grew up, you go downtown and there are lot of shuttered stores. It used to be where you went when you were a kid and now nobody goes there anymore.

SUBLETT: We have done it sparingly, in that we do have a small loan program where we go down now to a half million. But generally when we get down to those small loan areas, we are doing them recourse. And you are looking a lot more at the track record of that property and the financial strength of that borrower, and you are doing it more like a traditional bank loan as opposed to a larger conduit securitized loan. We do it on a case-by-case basis.

You are really looking at the financial strength, and you are looking at the track record of that property and the strength of the overall market. Some of the East Coast communities especially still have very vibrant downtown areas.. like the main street retail. It gets awfully cumbersome when you get into the mixed-use properties and trying to underwrite retail portions and multi-family portions and office portions. There is a point in time you say, it's just too messy. it's just too hard to analyze all of the markets on those various property types, and you move on to the next deal.

BURKHALTER: It's interesting. I have a couple of clients in Los Angeles that are doing some of this kind of recirculation of these sites. If it's a boutique or upscale neighborhood, we have seen some pretty good participation on the permanent side. Usually it's been either two product types, apartments and then retail, and then they'll just blend the pricing and the debt coverage and loan to value and try to simplify it that way.

I have got a deal right now, I am amazed that there is actually quite a bit of competition. There is office, apartment and retail, but it's kind of a main and main of a very upscale neighborhood with extremely high income. So it is an exception to the generality.

VERRONE: I think if you are on Main and Main in Greenwich or Main and Main in Beverly Hills or Main and Main in parts of Charlotte, the people are much the same. If the Dow drops another 25%, those people are still going to spend 8 bucks on a movie ticket and 14 bucks on a sandwich. It's not going to change it too much.

BURKHALTER: I have actually seen some mall owners really use their clout with some of these retailers where they won't let them out of radius provisions, because some of these retailers want to go to the main street. I have seen them actually step in the way and use their clout, which tells me that they are threatened by the main street retail.

DAVIS: Somewhat of a warm weather condition; Florida.

BURKHALTER: It is. It's easy to say from California to Florida. Yes, it's true.

DAVIS: What about the securitized pools you are putting in? I am assuming there are multiple property type conduits. Will we see less retail this year? Any difference in the mix?

SUBLETT: I think there is always the perfect mix that everybody is striving for, so much multi-family, so much retail. And to a large extent you can't ever get enough truly anchored, grocery-anchored retail, the traditional. It's golden.

It's just as golden as the class A or strong B multi-family. It's the primo stuff that you always strive for, and we are always battling the life companies for that. There is a concern about the unanchored and weekly anchored retail, because the general feeling is with a weakening economy, that's where the impact is going to be felt.

VERRONE: I think you'll find that if the spreads gets high enough, people will deal. If someone came to me and said, do you want to do an unanchored deal, if things go great, you'll make 2 points; if things go crappy, you'll lose. Not a great trade. But if the supply balance, enough bids, and I can start making 4 or 5 points maybe on a potential unanchored deal, I will take a few more bets. I will step in.

SUBLETT: Do you feel the same way about the big box?

VERRONE: Yes, I'll make some of those bets. I personally don't use a lot of big box. I personally am not a huge fan of that. I have never shopped. I drive by them all the time, but I never go in them.

SEALE: It's largely a credit decision, then, right? Because you feel differently about a Walmart or a Home Depot than you do about, I don't know, Office Max.

VERRONE: I am thinking of Bed, Bath and Beyond, to be honest with you.

SEALE: Within their sector they dominate. So I think it's important that if you are going to do big box bets, you are playing No. 1 and No. 2 player in this sector, it's pretty clear that Linens, and Bed, Bath and Beyond, no one else is going to take that business away from them. Home Depot and Lowes, safe bets. But as you work down the credit, you have got to be comfortable that if your single B credit goes away, that you can turn the property.

BURKHALTER: We have seen a noticeable difference in the participation rate by different lenders between the first-year power center with the Walmarts and Home Depot versus a similar design center, the same MSA, not competing next to each other, but the same general MSA, where they have K-mart and what used to be Home Base, whatever they are going to be now.

We saw full participation on the first year-power center right out of the ground. The day it was stabilized it was financed with no operating history. It was a different story for the second tier. Most lenders just, probably half of them passed on it. The other half maybe saw a pricing opportunity, if they believed in the dirt. That's probably the case, in this particular comparison, was a very good piece of dirt, but it was all second-tiered credits.

And the lenders who chose not to participate or quote, just without any sales history, they just weren't sure how that specific location was going to do, knowing that the balance sheet wasn't a response to the credit.

VERRONE: People are still very aggressive for Home Depots, Wal-Marts, Super Wal-Marts. Everyone is out after that business.

FITZPATRICK: I wouldn't say the economy is bad, though. I think it's slowing down a little bit. I think everybody anticipates that. And I think in retail, people are concerned about that and what the implications are. But I hope we are all right here, but I don't see the recession that we saw in the early '90s hitting us again right now. Who knows, it could happen. So it's, as I say, it's slowing down.

VACHON: You would say in general it would be a soft landing?

FITZPATRICK: Hopefully.

HANTGES: Well, I would be less optimistic if interest rates, the last two interest rates by the Fed were up as opposed to down. I think my feeling about the economy is, even though it's not great at the moment, it's optimistic, because rates are trending down, and if we get a tax cut, that certainly is not going to hurt.

BURKHALTER: That's good. That will be good for retail. I think that could be a very bright spot, because the majority of those dollars will probably be circulating in retail sales because we are a consumer kind of nation.

SUBLETT: I think the general feeling is to be cautious and be aware of where the issues are and be a little more selective. But certainly don't put on the brakes. We have all made the point, especially from the interim and from the construction side, to carefully choose your clients. Go with the people that are tried and true, and they are going to be there, and they are going to help you get through. Be a little more selective about who it is that you are getting into bed with.

VACHON: How would you say that your Internet lending is changing? Obviously I have to bring up the dot-com situation, but how have you adjusted your businesses to encompass Internet lending or your customers on the Internet, and how have you seen that changing?

BURKHALTER: For us our Web site and e-mail, in a lot of ways is just like when the fax machine came out years ago, it's a tool. It hasn't really had the effect I think that some people feared it would have. I think it's just a medium. You know, home loans, I have just financed my home on the Internet, but within hours a live body had to call me because she had questions,. There are some subtleties; who am I, what kind of person am I, that really couldn't be ascertained over the Internet.

HANTGES: Did you get the loan?

BURKHALTER: Yes, I did. It was a pretty seamless process. I was pretty satisfied with it. And there was a cost savings on the residential side. I think it's much more applicable on the residential side. If you get into a retail side — I'm not sure how you can quantify a retail site with the layout or how the traffic or demographics work — as easily on an Internet platform.

VERRONE: I think the jury is still out whether you could lend money over the Internet. The great thing about the Internet is the credit guy wants to pull up all the information on a publicly traded company for some 5 million. And he gets the package. The next thing you know he's downloading the web site. He's either going into a Securities and Exchange Commission. He can go into CoStar. He can pull up Comps. Whatever he needs to do, you just have complete access. You need to check the brokerage package for some facts. That's what we use the Internet for. It's a huge tool and to gather information to make a credit decision.

VACHON: Has it made your businesses easier?

VERRONE: More efficient.

BURKHALTER: More information perfection, and you get more information than you normally could in a short time frame.

SUBLETT: A lot of organizations looked into the Internet from the standpoint of the submissions and solicitation of business. I would say that this conference is certainly proof that we are not there yet when it comes to the Internet.

On the commercial side, we are very much a people business, very much a see it, touch it, feel it, discuss it. And the efficiency or hit rate that we see with submissions coming through the Internet is incredibly low. They tend to be tire kickers. They tend to be much smaller loans.

The people that are involved in financing or building the properties of the size that most of us are involved in, deal more with people face-to-face. They have relationships. Years from now the Internet will be there as we kind of roll through the generational thing. For the time being the relationship is king.

FITZPATRICK: The other thing, I think, was the underwriting side of this. I guess in '97, we all started to be worried, well, nobody is going to go shop live anymore. They are just going to go on the computer and do it. Today, I don't think we even think about it in terms of underwriting.

I remember Bobby Toppin wrote a great story in the Journal about this, and he was so right. He said this is not a big part of our business. I mean, these are huge numbers, but then he started giving statistics of what regional malls do on a daily basis. And it would dwarf it. And he was right. I remember that year. That was the big thing. How do we underwrite this? The Internet is going to take over. We are all going to be in trouble. It's not an issue.

LEIBOVITZ: I just met with in Birmingham, E-Centric. They are attorneys, and they have lender backgrounds. Their company comes in and streamlines the document process. It's so impressive that they have got everything automated, and you all can pull up what you need, and there is no cutting and pasting. It will be really helpful from a time savings standpoint. It's not necessarily the actual loan but the document process that improves. Do you think this is true?

VERRONE: It's already saving time. If you are closing a loan, and your attorney e-mails a note to the borrower's attorney ... I almost forget how we used to close loans two years ago. There are a bunch of systems out there. The problem is there are still a lot of attorneys who like to touch and feel paper and not work off of computers.

SUBLETT: I think e-mailing documents and things of that nature are incredibly efficient, but it is still a business that involves the negotiation. No one is going to take a $10 million loan and not go through every letter of that document and many times want to negotiate.

HANTGES: I don't think anything has changed in that regard in the last 10 years.

BURKHALTER: It's called verbal positioning.

HANTGES: You still need to know what's going on in that document. You still need to read it. You still need to sign it. You can transmit electronically, but ...

BURKHALTER: I think a service like that is good for our industry and good for the economy. It's a support function.

VACHON: Do think that is a generational thing that will phase, or do you think it will be the same?

SUBLETT: No. I think there are always going to be lawyers, and they are always going to need to do their job, to feel like they are negotiating on behalf of their tenant. I think we are a long way away from an attorney saying, "I'll take your canned documents and give them to my client for signature." It's not going to happen.

BURKHALTER: There are just too many unique issues.

SEALE: Technology will become a more important part of the process. Some of the things that I think are exciting, we are trying to implement, are making the documents available electronically to our bond buyers. Rather than shipping them a hundred boxes worth of stuff that they could care less about, they can say, okay, here's the transaction I am interested in. I want to see the appraisal on this and be able to have it accessible instantly, electronically. That's the kind of thing I think is really going to enable better information flow, more complete due diligence for the bond buyers.

VACHON: What about consolidation? We have heard a lot about that over the last few months, consolidating tasks, in other words, having someone do the work for you rather than doing it yourself. Is that something that you guys are seeing, or has that been in your industry? Outsourcing.

VERRONE: On the loan side? Credit decisions or legal decisions are made by in-house staff. That's a model, I think, that is shared by a lot of the originators out there, but there are some out there that keep smaller staffs and outsource a lot of the process.

SUBLETT: I think we saw explosive expansion from the securitized side of the business in the last few years, and that's where there was an awful lot of outsourcing, contract label. Everyone was adding people on.

I think one of the things that’s interesting about this conference is that there isn’t a lot of new news and there isn’t any explosive expansion. I think most shops have come to the point that there is a certain degree of stability. They are much more comfortable doing it with their own people. They have confidence in their own folks .

FITZPATRICK: We get rated on that process. That's a very important thing. And it relates to the subordination levels we get from the rating agencies. They like seeing the people who are doing the work. I mean, there were some shops, but most of them are now gone, who were trying that model, and it was an interesting way of doing things, but it's just, I don't know, almost like pride of origination, and your name's on it. I mean, you can get tagged by the market if they figure out that you are not doing your work correctly. There’s much better control if there are employees that you see every day.

SUBLETT: I think especially from the bank standpoint. I am not saying that the Wall Street firms do not have that same pride, but the banks make a big deal about things that our name is on. We want to know that it was done right.

DAVIS: From the borrower's side, there has been a lot of — you used the word — consolidation. There have been a lot of mergers the past couple of months. Do you think this creates some confusion out there until they know how these new entities are going to perform in the market, or are there any other differences, or is that not just a factor?

FITZPATRICK: You mean like some of the Wall Street firms?

DAVIS: Yes.

VERRONE: There is definitely confusion, but it's not slowing them down. I mean, they have to wait for the smoke to settle and find out who won, JP Morgan or Chase.

BURKHALTER: Or CS First Boston and DLJ.

VERRONE: Read the commercial mortgage list, find out if your loan officer is still working. But very few people just get one bid. They are out there talking to the six other people who haven't merged. But what you have now is huge balance sheets that are chasing deals.

SUBLETT: I think it has an impact on the mortgage banking on the mediary side from the standpoint that you had two correspondents and now you have one.

BURKHALTER: Yes, there is some of that. Yes, that's true. That's all I can say. There are fewer capital sources. But two years ago there were too many. It was confusing. It was hard to stay in touch with everybody. But the entities that are merged, and they are already known entities — DLJ and CS First Boston and Chase and JP Morgan. It's a matter of asking if your particular contact still there and who won the battle?

VACHON: What would you say last year was the most interesting thing that happened to affect our industry last year and how will that change in the coming year?

VERRONE: Just define industry. Shopping center, retail finance?

VACHON: Yes, exactly.

BURKHALTER: We didn't have any melt downs last year, so it's the first time in three years. They were relatively calm years.

SUBLETT: I don't think that anything stands out. It's sort of the tone of this conference. There is nothing earthshaking.

BURKHALTER: We are not worried about the dot.coms.

FITZPATRICK: But think about it, nothing happened in 2000. Now, if you roll to 2001, in January, we all come back from vacation and every day there was another event going.

SUBLETT: It was Office Max. It was Office Depot. It was Sears. It was Eckerds, J.C. Penney. It was another theater movie chain. this was especially true from a servicing standpoint. On Monday the e-mail comes out about so and so is closing so many. On Tuesday we are going through the portfolio to see where our exposure is and see what we have either in the servicing side or in the pipeline. It was at least once a week.

FITZPATRICK: Montgomery Wards and Bradlees closed. These are big names that have been around for quite a while.

SEALE: I actually think those are healthy, though, for the state of the retail world, because it's the survival of the fittest, right?

SUBLETT: Drive a stake through them. Instead of having a Montgomery Ward linger and linger and linger, we know that it's a done deal.

BURKHALTER: Long overdue.

FITZPATRICK: It is interesting, because we are working on a mall right now. It was a Montgomery Ward which went, and it was already replaced with a Kaufman's. Great operators. This is such a good thing for this mall. Montgomery Ward was just crawling along, not really doing very well.

SEALE: And for your centers as well — right? You get rid of the real weak. If they are dragging, nobody wants to be next to those operators. Kaufman's comes in and suddenly it's great for everybody.

FITZPATRICK: The in-line stores that were all dark around Montgomery Wards, have jacked the rents in those spaces dramatically just for that reason, because that's the hot spot.

BURKHALTER: In quite a few cases we saw Montgomery Wards was open. We think part of the reason they are open because they are paying cents a foot in rent. Is that a reason to be in the retail business?

SEALE: Well, in bankruptcy that is going to be one of their biggest assets.

BURKHALTER: Oh, yes, the leasehold.

SUBLETT: I think that is one of the things that is a concern as a lender and a servicer is the work through of some of this stuff, because as a lender, one of the best things to have happen, if you have got a tenant that is struggling or they go into bankruptcy is let's get in, let's get out. Let's figure out what the plan is. Let's either put somebody new in. But it's when you languish in that middle ground of bankruptcy, and are they going to reaffirm, or are they going to reopen, or were they selling that lease, that's where you really struggle because the whole property will suffer as a result.

VERRONE: You mentioned the Internet earlier. There is a bankruptcy dot.com or something. Every morning when I log in, I get an e-mail of what and who personally filed for bankruptcy.

HANTGES: How did get you on that list?

VERRONE: One of the credit guys in First Union installed it on everyone's tickets, free service, and you walk in and you know who filed for bankruptcy.

SEALE: Way to start your day.

SUBLETT: Start your day off with that note.

SEALE: Is there an obituary dot.com too?

BURKHALTER: I think the same people own them.

VACHON: Well, is there anything anyone anticipates or predicts for the upcoming year as far as how we'll do or where the new trends will be? Any predictions that we can look at next year and see what happens?

FITZPATRICK: I think retail will be better than people think.

SEALE: Absolutely.

FITZPATRICK: I really do think that. It's actually a good thing, because you are going to lose some peripheral pieces of business that probably shouldn't be there anyway. They are going to fade.

It's interesting to walk the anchors these days; just the operators who are around, like Penney. I don't really like Penney's. I was in their store recently, in the mall I was looking at. I was in there two minutes before one of the salespeople walked up to me, had said, “How are you? What you like to do buy today?" Two minutes in their store! You walk into some of the other ones that are now on line; you couldn't even find salespeople. To me that is a very interesting underwriting. I always do that. I walk into a store just to see if anybody notices I'm there, if they are going to try to sell me something.

BURKHALTER: They kind of picked it up from Walmart, the greeters. That is an emerging trend with some of these retailers.

FITZPATRICK: People like it, and it gets you from thinking of buying to a buy decision. It's very interesting to see.

BURKHALTER: Having a good retail experience is becoming much more important. If you buy standard Levis over the Internet, you don't care if you are buying them from somebody in India. If you find them cheap, it's a commodity. But the retail experience, if it's something that's a little more boutiqueish or it's a restaurant experience, is important.

With one of our key retail developers, the valet parking people must remember your name and tell you, "Fitzpatrick, we hope you have a good time at the blah, blah, blah center." You can have a message right below your bankruptcy.com that says "Welcome, Verrone," but it's not the same as someone saying it to your face.

FITZPATRICK: I think retail, if we all work on it, is going to be pretty good. What they are going to defer buying is probably a new car or a new house or a second home. That's what I think the money is not going to be around for. But they are going to go to the mall, buy a T-shirt, a new pair of pants, probably a new TV, stuff like that. That's going to be okay in this kind of recession, if it's slowing down.

I'd really be worried about the auto business right now. I think those guys are going to have a bad year, I mean a really bad year. I have got two five-year old cars right now. Typically this is the year I roll off, not even continue my lease, but now I am just going to buy them out of a lease. I am not going to buy a new car.

BURKHALTER: One thing we have advised some of our investor clients is to stay away from home furnishing centers and stay with the grocery/drug anchored. We tell them, you may have to pay a lower cap rate, but going into a softer economy, we are a bit spoiled. We have had eight or nine years of great growth, so a little down tipping is ok.

HANTGES: It ought to continue.

BURKHALTER: A tax cut would be good. I'd like to see a little down payment on the national debt. That would be good for interest rates. But the home furnishing centers are one of the weaker businesses. It’s only one step away from the auto and the appliances stores.

SUBLETT: I think we'll see the construction side slow. I don't work in what I call the bank side. I'm on the construction side, but I definitely think the construction side is going to slow. And that will be a good thing for existing properties. You’ll have less inventory. Those that are there will focus on increasing their same store sales, and we'll see a little bit of stabilization as opposed to continued rapid growth. I think that's a good thing.

BURKHALTER: I am very optimistic in short-term and midterm as far as the availability of permanent debt capital for retail, because particularly on the securitized lending side, the Fannie Mae, Freddie Mack agencies really have such a huge market share on the multi-family side. The insurance companies are continuing to do a very good job of financing industrial, five-year leases that are leaning into the market. It's difficult to disseminate that to fit your Moody's or S & P. So what product, major product types does that leave for the C & B side? It leaves office and retail. I think those are going to continue to be a very important food group, if you will, or product type for the securitized lenders.

VERRONE: I think Fannie and Freddie on the multi side does have an advantage, but I looked at that chart yesterday, and it was interesting that Fannie did 14 million of multis and conduits of 14 million of multis, so I think we are still going to get plenty of that paper. But, yes, retail and office is where it's at, where you get a little bit of a deal, but you could take good bets.

I have no idea whether we are going into a recession or not. Yesterday I was watching CNN and they interviewed four or five people, and every person said they were going to cut back on spending, and they were going to put more toward savings. Some people say the Mid West is already in a recession. I just haven't felt it yet. I haven't really seen it.

SEALE: Someone pointed out the other day that it's still very tough to get into the prime New York restaurants. That until that stops, we are not in a recession. People are clamoring to pay whatever it is for the meals.

VERRONE: I think there is a center in Charlotte that has done great so far. I'm just curious if it's going to continue to do great. It's in a great location in an affluent area. But there is a golf store where the average golf shirt is 400 bucks. It's $200 or $300 for golf shirts and $50 for socks. Those stores are going to drop down, but the grocery anchored stuff is going to be fine.

VACHON: Well, our time is pretty much up, but I want to thank you all of you for coming and for taking the time to participate. It's been a pleasure working with you and getting to know you over the phone, and now I can put a face with a name. So thank you for participating. If you would like to stay and have coffee and just chat, feel free, but I know that you all have busy days, and I appreciate your taking the time.

FITZPATRICK: Thank you for having us.