- Change in shopping habits shifts retailers’ fortunes
- E-commerce has taken away market share and there is more to come
- Closures create opportunities to revitalise and modernise
- Solutions include adding entertainment and lifestyle facilities
The encouraging start to 2019 for retail REITs in the US and Europe cannot paper over the widening cracks in the consumer landscape facing owners of shops, shopping centres and large-scale malls. The last three years have been awful for most retail landlords across the world as not only online shopping, but digital developments more broadly altered consumer habits. Consumers with the money to spend no longer follow brands, they follow influencers on social media.
And the structural issues enveloping the retail sector should persist for the foreseeable future. Nonetheless, many investors will be asking when is the appropriate time to shop retail real estate again given the significant price changes in retail REITs across the world and what, at face value, appear to be attractive valuations.
Shop until you drop
Regional mall and shopping centre REITs have had a pretty tough time since 2015. Retail REITs have underperforming broader REITS significantly in the past three years, reflecting the weaker demand from retailers for space across the world amid rising bankruptcies. Falling occupancy rates, the higher costs of backfilling space vacated by bankrupt companies and falling rates of income growth have seen REIT investors turn their back on the sector, particularly in Europe and North America.
Exhibit 1: Performance of global listed retail real estate companies versus all listed real estate companies
Source: FTSE EPRA NAREIT, Bloomberg, data as of 31/12/2018
The sharp selloff has meant that valuations now look attractive. The European retail index is down by 45% over three years and the equivalent US index has fallen by 20%. Consequently, European real estate companies currently offer a dividend yield of 8.4% (Bloomberg, January 2019), while their US equivalents are yielding 5.3%. These are appealing levels given that the US 10-year government bond yield has now fallen to around 2.7%.
Click and collect
As said, high-street and shopping centres have had a fairly miserable couple of years in the face of relentless competition from e-commerce. Many retail REITs saw property values falling at a time when property prices in other sectors rose steadily. Although 2018 saw a change in part of the landscape as the profits of some online retailers plunged and consumer giants such as Amazon came under pressure, the growth of e-commerce has not relented.
Online sales vary across the world, showing considerable penetration in Europe and America, but with substantial scope for growth remaining. As one of the most advanced markets, the UK, for example, is a global leader: 20% of retail transactions take place online compared to 5.9% in Australia (UK ONS, November 2018; ABS, October 2018) while in the US, just under 10% of total sales in Q3 2018 were online (US Census Bureau). Clearly, based on the UK experience, the scope for further growth at the expense of physical retail is sizeable.
The other major structural challenge facing retailers in many countries is that there is far too much space to choose from.
Exhibit 2: Shopping space stock by country in terms of square metres per capita
Source: AT Kearney, The Future of Shopping Centres, 2018, BNPP AM, Swedish Trade and Investment Council, 2017
The US is by some way the best supplied shopping destination from a consumer’s perspective. Clearly, the US is a massive country and there are significant regional and city differences, but the relative level of supply to population is still eye-catching, as are the levels in Canada and Australia. By way of comparison, European markets look less challenged. Nonetheless, this should not lead to the conclusion that there are fewer issues for European property owners. Clearly, a key factor is the nature of supply available to shoppers and the type of the catchment areas that properties are in, but the figures are still illuminating.
Food for thought
Falling high-street and shopping centre occupancy rates have led landlords to resort to a variety of capital-intensive strategies to improve these. As stores close, landlords have to overcome the perception that the entire property or centre is failing or risk losing other tenants. But store closings can also create opportunities to revitalise retail spaces and release space to more modern tenants paying higher rents. This would require considerable innovation and money to revitalise the dead space.
Property owners have increasingly looked to the food and beverages segments to attract shoppers as part of their response to increased competition. More recently, even these operators have started to struggle. In the UK, for example, the number of restaurant insolvencies was up by 24% in 2018 compared with 2017 (Bloomberg, January 2019). Other solutions have been to expand further into the entertainment and lifestyle segments, adding cinemas, fitness centres and spas to the growing number of restaurants, along with casinos and betting shops.
The longer-term and more expensive solution seen by a number of REITs is densification intended to bring in a consistent number of shoppers and raise rents. Companies have added hotels, apartments and offices to replace and reinvigorate space left by failed department stores. Previously, they would have been replaced by gyms, restaurants or smaller-format retailers.
The sharp fall in the stock prices of retail REITs across the world in recent years suggests investors may have priced in a number of the current struggles. Despite the apparently lower valuations, the outlook remains challenging and the ability for landlords to survive will depend on their ability to finance the changes needed to adjust. Online penetration is likely to grow further despite the setbacks by some online retailers in Q4 2018. The demise of restaurant chains in the UK shows the solutions to the retail mix can be short-lived.
Capital-intensive redevelopment or mixed-use developments appear to be the sustainable options. The changing landscape and continued store closings since 2016 have exaggerated the gap between higher and lower-quality properties. Retail REITs will need to raise asset quality and improve the shopping mix through redevelopment. Densification costs considerable amounts and only a handful of companies appear to have the balance sheet strength to embark on this route.
It is safe to assume that there will be further shop closures. But well-capitalised landlords with the best quality properties should be able to attract successful formulas to vacant spaces and thus improve occupancy rates and ultimately increase their net operating income.
 Real estate investment trusts