Shopping centres account for nearly 15% of total retail floorspace in the UK. Costar estimates that there are more than 1,400 shopping centres across the UK of which only 276 are classified as “Prime” or “Major Urban”. While representing less than 20% of shopping centres by number, these dominant schemes account for nearly 50% of total shopping centre floor space on their database. The space that remains is spread across more than 1,100 schemes which are variously defined as “Urban”, “District” or “Neighbourhood” but all of which, in investment parlance, might be labelled “Secondary” or even “Tertiary” shopping centres. Many of these secondary schemes are now dated and visibly starting to struggle. The logic that led to their initial development is increasingly undermined by the growth of online sales and the preference of consumers for more convenient retail parks on the edge of town centres.
All shopping centres face huge challenges as they compete for a dwindling population of occupiers. The traditional tenants of secondary schemes in particular are retrenching. A number of retail failures in recent years have left big holes that are difficult for landlords to fill. In recent years the response of asset managers to diminishing demand from traditional retailers has been to turn to the casual dining and leisure markets to mop up surplus space. These levers are now becoming increasingly difficult to pull as a combination of the squeeze on disposable income and overexpansion by the operators dry up demand. The consequence is that both occupiers and investors are pursuing a “flight to quality” focussing on only the best assets in the best locations.
The future challenges for anything but the best shopping centres have been highlighted by the recently announced Hammerson/Intu and Westfield/Unibail merger deals. While very different in terms of sheer scale, both transactions suggest an acknowledgement that long term value and sustainable growth will increasingly be concentrated in the biggest and the best schemes. Funds realised from any disposals of weaker assets can be applied to reduce gearing and reinvest in maintaining the primacy of the best assets. In this respect, it is telling that Westfield publicly differentiate between their “Flagship” and “Regional” shopping centres in their reporting. This split indicates how the biggest players now perceive their portfolios and disclose their results in order to differentiate themselves to investors and reinforce the message about the strength of their assets in comparison to the wider sector.
Traditional “General retail” is no longer the mainstay and driver of value in the biggest and strongest “Flagship” schemes.
A side by side comparison between flagship and regional demonstrates the changing focus of modern retail space.
Source: Westfield H1 2017 financial results presentation
This merger activity and the drivers behind it raise important questions for holders of secondary shopping centre assets. Deloitte has analysed reported transactions since Jan 2007 in respect of more than 260 “secondary” shopping centres1 covering more than 44m sq.ft. of space with a total transaction value of £12bn. The period from 2010 saw substantial transaction volumes of this stock. Since a peak in 2015, both transaction volumes and prices per square foot dropped to a point where the market is now all but stagnant.
Source: Deloitte Research/Costar
Of equal note is the change in the ownership base for this type of asset since 2007. Property companies, banks and administrators have disposed of stock which has subsequently been snapped up by pension funds, REITs, private equity and, increasingly, Local Authorities.
Source: Deloitte Research
Each group that has been active in the market will have had their own motivation for increasing their holdings and will develop their own responses to the current conditions. However, for all of them there is a risk that any permanent market pricing correction arising from the “new normal” of diminishing occupier demand for bricks-and-mortar stores could undermine their plans. Indeed, if the opinion of the markets is anything to go by, the new body of investors seems to be swimming against the tide. Market scepticism could be said to be demonstrated by the significant discount to NAV witnessed for a number of the REITS specialising in this sector with secondary shopping centres featuring prominently in their portfolios.
Those who bought in to the market in anticipation of a recovery in occupier demand or a significant yield shift have been frustrated. A number of schemes and, indeed, portfolios have failed to find buyers on the turn hampered by a market perception that many schemes remain over rented and, consequently, overpriced. The response is to refinance and wait for the market to improve. It could prove to be a long wait.
Local Authorities have been surprisingly active in the market, spotting a potential arbitrage between cheap money and high yielding secondary shopping centres. But there is more to it than that, particularly where Local Authorities see themselves as guardians of their own town centres in areas that are no longer attractive to private sector investors. Kick starting local regeneration while contributing valuable revenue to support council services is a noble intention but, as an asset class, secondary shopping centres are labour intensive and require specialist management with a clearly defined long term vision. In this difficult climate the challenge for Local Authorities will be to ensure that their town centres are paved with more than good intentions.
Occupier demand is key to the sustainability of this asset class but Deloitte’s analysis suggests that secondary shopping centres are increasingly dependent on a dwindling pool of core occupiers. The sector is particularly sensitive to the failure of large, multiple retailers, but there is also the worrying steady attrition of units as occupiers across the spectrum of “general retail” face up to their own particular online disruptions and right size their portfolios - emptying the rental income bucket faster than hard-working asset managers and agents can refill it.
Frequency with which each retailer is recognised as one of the top 3 “anchor” tenants in secondary shopping centres transacted 2007 - 2017
Source: Deloitte Research
The first major increase in retailer insolvencies for 5 years and particularly the significant increase (55%) in the number of large retailers ( those with more than 10 stores) that have gone into administration shows just how challenging the market is for retailers with large bricks and mortar portfolios to trade profitably. Within this general malaise is a swathe of CVAs with retailers seeking rent concessions from landlords in order to survive.
This trend hints at a fundamental disconnect between the contractual rent and retailers’ ability to generate a reasonable return from their space in the face of dwindling footfall and the challenges of online. In anything but the most prime locations it seems likely that a new rental model that better reflects an economically sustainable cost for the space will ultimately be forced on landlords. In the first instance, this is likely to take the form of a wider reliance on turnover rents. This may prove challenging and countercultural for both landlords and tenants; with landlords forced into a closer involvement in the trading performance of their tenants while retailers will need to get more comfortable with sharing their sales figures with their landlords.
So, if the current state of the market does represent a “new normal” what new strategies will need to be deployed if value is to be enhanced or, at least, maintained?
The existing asset management levers of reconfiguring and re-letting will need to be pulled more vigorously than ever but, in addition to this, the repurposing of space to redress the balance between supply and demand will need to be actively pursued. Conversion from retail to residential is a much discussed route and there are several good examples of this already (and a hint of potential government support in a recent White Paper) but it may not be as simple as that. Shopping centres are large and complex structures and not nearly as easy to redevelop cost effectively as an outdated office box. The dynamics of the local property market will dictate if such redevelopment makes financial sense. The fear must be that in many locations where the lack of tenant demand might make such an approach attractive, the cost of redevelopment coupled with depressed local house prices may render any such strategy uneconomical. What then?
Realistic valuation will need to underpin the regeneration of secondary shopping centres. Whether that means a fundamental “correction” in the face of the structural changes challenging the market remains to be seen. For now, the investment market in secondary stock has all but ground to a halt with a variety of investors left holding the parcel after the music has stopped (and scared to unwrap it). In the absence of any dramatic recovery in the occupier market, pricing is likely to come under sustained pressure, driven by the weight of stock on the market and potentially exacerbated by yet more as the major players start to weed out their weaker assets. 2018 could be a year to watch!
1 “Secondary” is here defined as schemes categorised as “District” or “Urban” by Costar with a transaction value in excess of £10m