coverage had not affected the amount or terms of the loan. Thus, rent-paying ability does not necessarily depend on the credit standing of the tenants. Insurance companies, therefore, are forced to rely on their ability to analyze a particular market, prospective competition and the sales potentials of individual classes of tenants in order to assess rent-paying ability. Summary This chapter examines the nature of lending requirements employed in financing shopping centers. Insurance companies are guided by certain investment requirements in their efforts to satisfy the objective of maximum return. These requirements are (1) safety of principal, (2) stability of income and (3) satisfaction of legal restrictions. The attractive return on shopping centers allows insurance companies to contribute toward maximizing investment return. The satisfaction of investment requirements depends on the income from the property. The uncertainty and explosive growth of suburban retailing has caused lenders to rely on the rent-paying ability of tenants for security of income. Insurance companies appraise rent-paying ability by analyzing trading area support and the financial strength of retail tenants whose minimum rents provide coverage of debt service plus taxes and expenses. Other factors such as location, center sponsorship and center design are evaluated for their favorable or adverse impact on rent-paying ability. Once rent-paying ability is reasonably assured, the lender uses the rents to determine the value of the center for loan purposes. The lender's emphasis on rent-paying ability tends to indicate that life insurance companies consider national chains and large department stores as very important to secure their approval of shopping center loans. However, several factors dispute the premise that lenders really rely as heavily on credit standing of major retailers as critics claim. The flexibility of lenders is illustrated by the variation which is possible in the application of the coverage formula depending on the level of minimum rents and operating expenses. In addition, lenders tend to deviate from strict application of the formula when a center looks very attractive to them. Moreover, not all top-credit national chains are considered as key tenants for loan purposes by insurance companies. Nor will the aggregate lease term correspond with the requirement for full coverage throughout the life of the loan. Finally, the definition of key tenants is flexible. As a result, credit coverage is often not satisfied, or even sought, in practice. THE PRESSURE OF MAXIMUM DEBT RENT STRUCTURE If the credit requirements of the lending institutions are only a symptom of why independent retailers have difficulty obtaining prime retail locations, as the preceding chapter suggests, what then explains the absence of many small business concerns from suburban shopping centers? This chapter contends that the usual objective of the developer to build an expensive retail complex, as measured by capital costs, with only a minimum equity investment imposes a barrier on the ability of local small-space retailers to operate profitably in a center location. The eagerness of the developer to borrow the largest possible amount, either out of necessity or a desire to maximize his equity return, is believed responsible for the tendency of many developers to lease more space than really worthwhile to mass-merchandise national chains. The allocation of large amounts of building space to low-priced national chain operations not only sets a low quality image for the center, but the low rentals paid by these chains, together with whatever the anchor department store agrees to pay, dictates the rent structure for the entire center. The presence and advertising power of a major department store tenant is recognized as absolutely essential for the customer drawing power and permanent financing of the center, as well as necessary for the attraction of a complementary assortment of small-space apparel and specialty line retailers as tenants for the center. However, the developer must make up for the command of low rentals by the largest space-using tenants by charging higher than average rentals to small space tenants. Many otherwise desirable small space retailers cannot realistically consider occupancy under such circumstances. The developer either fails to fill all of the space, or he compensates for his leasing inadequacies by filling the remaining space with an assortment of retail or nonretail tenants that add little to the merchandising strength of the center. Contrary to the popular assumption that leases are well thought out and planned to assemble a proper tenant mix to serve a trading area, real estate financing considerations often predominate over merchandising considerations in the planning of shoping centers. The heavy reliance on maximum debt financing imposes a constraint on the ability of a developer to assemble the most desirable combination of large and small tenants. The difficulty that developers encounter in signing desirable small-space tenants is most apparent in newly opened centers which typically suffer a higher rate of vacant space than older, established centers. According to a study of shopping center vacancy patterns by the International Council of Shopping Centers, Inc.,1 vacant space accounts for an average 6.7 per cent of the area in the neighborhood centers, classified as being less than 100,000 square feet in space, that had been opened for less than two years. New centers that meet the classification requirement for regional centers by having more than 300,000 square feet typically had 4.2 per cent of their total area vacant. The report also revealed that 57 per cent of the 272 centers of all ages surveyed reported vacant space. Fourteen per cent of the centers reported a vacancy rate in excess of 5 per cent to the total space. The presence of vacant space means lost profit opportunities for the shopping center developer because the small tenants that would normally fill this empty space pay the highest rent per square foot and yield the developer the largest return per square foot. The Pressure for Maximum Financing Shopping center developers experience significant pressure to maximize the amount of mortgage financing for their center projects. Few developers are willing or able to invest a substantial amount of equity capital in a single center project 1 Perry Meyers, The Vacancy Factor in Shopping Centers, New York, International Council of Shopping Centers, Inc. Shopping Center Report No. 19, 1966. shopping center, including land and improvements, is $2,500,000, and a mortgage appraiser only values the completed center at $3,000,000, on the basis of assured income from leases signed by financially strong tenants, then a conventional mortgage loan for about $2,000,000 can be anticipated. This still leaves $500,000 in equity to be supplied by the developer. Investing such a sum into a single center project would not strongly appeal to most developers, even if they were able to do so. Thus, a critical factor in any large center project is the ratio of available mortgage financing to the total capital costs. The statutory restrictions of the various states on life insurance company investments, which place an upper limit on the amount that can be loaned on a given appraised value -usually set at two-thirds of the appraised value, presents an obstacle which the developer must overcome. The developer must contrive a means to minimize the spread between the cost of the project and the financing available on the real estate. He desires to minimize this gap, and maximize his mortgage financing by securing the highest possible level of average rental income. Unless he obtains the necessary level of average rents, the developer is likely to realize, after signing his tenants that the spread between the amount of mortgage money he can borrow and the total costs of the project is too large for the amount of equity money available and the opportunities for profit are too limited. This situation can occur because the amount of the mortgage loan is based on the minimum rental schedule stipulated in the tenant leases. Expected income, rather than construction costs, determines the amount of the loan. The lender is not concerned with land costs, or what the developer has paid to build the center, or for what the project could be sold. The lender is only interested in the income that the piece of property will produce when the landlord erects a leased building on it. Difficulties in Tenant Selection A shopping center developer normally begins assembling the tenant-mix by inducing a large major retailer to be the anchor tenant. The rest of the center is built around this key retailer. The anchor tenant is invariably a department store in a regional center, or a junior department store in a com |