Has physical retail reached its nadir?

As shoppers have increasingly eschewed visiting high-street stores and out-of-town retail parks in favour of online shopping, declining physical sales have made meeting rental payments a tougher task. To the protestation of commercial landlords – who are often outvoted by other creditors – struggling retailers looking to reduce rental costs have increasingly passed company voluntary arrangements (CVAs), which allow a company to restructure its operations and cut debt. 

Yet while the controversial arrangements have garnered much of the attention centred on those battling to stay afloat, the pressures facing traders is causing a broader, fundamental shift in negotiations between retailers and their landlords. An uncertain trading environment has led retailers to agree to shorter lease lengths and landlords can no longer expect to secure new rents at a higher level than the passing rent when they come up for review. 

Indeed, rising pessimism over the extent to which rents will rise in future has pushed up yields attached to retail property portfolios in recent years, as the risk of owning these assets has ratcheted up. By the end of November, the average yield on high-street retail had risen to 5.25 per cent from 4.5 per cent a year earlier, according to research by estate agency Savills (SVS), and 5.75 per cent for shopping centres, from 5.25 per cent. 

“In a lot of cases it would be difficult to argue for an increase at rent review because of the type of deals that have been going through [across the wider market],” says Calum Bruce, investment manager at Ediston Property Investment Company, which owns a £319m portfolio of commercial property across England and Scotland. Retailers increasingly want to see rents being expressed as a percentage of their annual turnover, he adds.

Given the more precarious trading environment, some landlords are having to concede to making rents more affordable for tenants. “I would far rather have the yield softened by a lower rent and have a happy tenant that is going to be sustainable going forward,” says Gerry Frewin, manager of Columbia Threadneedle’s UK Property Authorised Investment Fund. That can maintain rents at review, he adds. 

Falling asset valuations and like-for-like rental income has caused profits to plummet for UK-listed real estate investment trusts (Reits) with retail exposure and, unsurprisingly, caused shares to trade at sharp discounts to net asset value (NAV). 

A buyer’s market?

Some property groups have managed to reduce their exposure to the sector by selling retail assets. They include LondonMetric (LMP), which counts just 4 per cent of its portfolio value in retail parks after doubling down on growing its urban logistics properties, which have benefited from the rise of ecommerce and demand for ‘last-mile’ delivery services. 

However, investment volumes within the retail property market have fallen dramatically over the past 12 months, as uncertainty abounds over the extent to which asset valuations will continue to fall. “Your initial [purchase] yield might be 8.5 per cent, but your cash flow may fall when you get to lease breaks and expiries,” says Mr Bruce. 

Potential sellers are also hesitant to dispose of assets at a distressed price. Commercial property developer and landlord Landsec (LAND), the UK’s largest listed property group by assets, recorded a 2 per cent decline in net rental income from its retail portfolio during the first half. Retail parks were the worst performer, suffering an 11 per cent fall, but while the group does not see these assets as part of its long-term future, according to chief financial officer Martin Greenslade, the time is not right to be disposing of these assets. “We don’t want to be joining a queue of forced sellers in the retail market,” he says. 

Attempting to change the use of retail sites is another option being considered by asset owners. In July, beleaguered landlord Intu (INTU) revealed plans to build 1,000 homes to rent at its Lakeside shopping centre site in Essex, aiming to put residents “right on the doorstep” of the mall. In total, the retail landlord has identified about 6,000 potential residential units across eight sites.

NewRiver Reit (NRR) – which recorded a 3.5 per cent decline in like-for-like rental income  during the six months to September – carried out a review of its portfolio last year to assess the potential for alternative use. Around 85 per cent of the alternative use was residential as many of the group’s sites are located in town centres. The group, which counts many convenience and discount retailers as its tenants, had an alternative use valuation for its retail portfolio of £848m, but that was 13 per cent below the retail portfolio valuation.

However, changing the use of retail sites into residential can be more complex in terms of gaining planning consent as an increase in the density of occupation would be required to make the development stack up for landlords – increasing build height is one of the areas where local authorities can feel uncomfortable. 

Not all retail landlords are feeling the pressure equally. While online grocery shopping has also been on the rise, supermarket store sales have held up better than non-food. Supermarket Reit (SUPR) managed to grow its EPRA [European Public Real Estate Association] earnings by almost a third last year and agreed rent reviews at an average 3.2 per cent above previous passing rents, in line with retail price index (RPI) inflation. The £500m fund was established two years ago ahead of new lease liability accounting standards coming into force, aiming to appeal to supermarkets wanting to take property off their balance sheets, and counts ‘big four’ grocery chains Tesco (TSCO) and Sainsbury (SBRY) among its tenants. 

The FTSE 100 and investment-grade status of its tenants is what appeals to the company, says co-founder of the Reit’s investment adviser Atrato Capital, Steve Windsor. He also cites the average rent-to-turnover ratio as between 3 and 5 per cent, compared with 30 per cent for fashion retail, as one factor that makes rental levels more sustainable. 

The company incorporates how a supermarket’s corporate debt is being priced by the market in comparison to property yields when assessing risk attached to tenants. A lease is a promise to pay an amount in the future, as is a bond, says Mr Windsor. “Hence we like to compare where bond markets price long-dated cash flows to our tenants compared with property markets,” he says. 

The spread between supermarket property yields and debt issued by supermarkets has widened. For example, Tesco 2029 corporate debt offers a yield of 2.5 per cent, compared with a yield of 5.2 per cent on supermarket property, according to the MSCI IPQ index.

Income under threat

For investors in Reits and open-ended property funds, falling rental income could mean dividend cuts and returns. Reits must pay out 90 per cent of taxable rental profits as dividends to shareholders, in exchange for their rental profits and capital gains on rental properties being exempt from corporation tax. 

The most secure dividends will be covered by rental profits, although they can also be paid from non-Reit income and disposal profits. Selling assets to meet payments is a riskier long-term strategy as there is no guarantee of the sale timing, price or even that a disposal will be achieved at all – in a market where retail assets have fallen out of favour, those are risks some landlords are particularly exposed to. That is particularly the case for larger assets, above £100m in value. 

The dividend yields offered by shares in some Reits have risen to more than 6 per cent, indicating the market’s scepticism that they will be sustained at current levels. Intu was forced to scrap its half-year dividend in August in a bid to shore up its balance sheet, and has said that an equity raise is likely, in addition to further asset disposals. Meanwhile, other landlords with retail exposure, including NewRiver Reit and UK Commercial Property Trust (UKCM), a Reit managed by Aberdeen Standard Investments, paid dividends that were only around 80 per cent covered by adjusted earnings last year. 

NewRiver said it is aiming to rebuild full dividend cover by the end of the next financial year by selling lower-yielding assets and reinvesting the proceeds into acquisitions that deliver higher rental income. Meanwhile, UKCM said earnings were on an “upward trajectory” following the acquisition of the Midlands distribution portfolio towards the year-end. 

For open-ended funds, the risks associated with a worsening environment for retailers has been highlighted by the M&G and, subsequent Prudential UK property fund, gatings and the ensuing contagion effect on peers. Open-ended real estate funds suffered their worst daily outflows since the aftermath of the referendum following the suspensions. “It really comes with a buyer beware on liquidity,” says Darius McDermott, managing director of financial advisory company Chelsea Financial Services. “The difference with investment trusts is they don’t have to sell properties because they’re listed companies.” 

Has physical retail reached its nadir? The market does not seem to think so, as yields on retail properties have continued to rise along with the likelihood of retailers continuing to bargain hard for rent reductions. Indeed, the average net effective rents for shopping centres had fallen by 26 per cent by the end of September compared with the prior year, almost 25 per cent for the high street and 7.5 per cent across retail parks, according to Savills research. For those landlords with a more diversified mix of assets, such as British Land and Landsec, discounted shares could offer good value income, but pure-play retail seems best avoided. 

Mr Kumar said there were three characteristics that retailers should have if they are to grow: flexibility, differentiation and scale. 

Flexible companies have the balance sheet firepower to invest, allowing them to streamline their online and offline businesses for maximum efficiency. “What we are seeing is an industry capital cycle at a phase of ‘creative destruction’,” he said. “Online retail drove significant change in price transparency and convenience. The failure of many retailers is due to their inability to adapt.” Scale feeds into this, with the ability to spread fixed costs over a large retail base allowing companies to offer greater range, price and service to customers, as well as making them attractive partners for large suppliers.

Inevitably, differentiation varies wildly from company to company, but Mr Kumar gave the example of Primark – whose low prices “can’t be found elsewhere” – or JD Sports and Watches of Switzerland (WOSG), which both have strong supplier relationships for exclusive products.<boxout>