Real estate: Can the high street survive this low?

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By:
Ben Edwards
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Investment in logistics assets is on the up, while interest in retail properties seems to be on the slide, dragged down by the sense that they are the past, not the future. But bricks and mortar may yet have some bounce in it.

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On the outskirts of the small UK town of Frimley, next to the steady hum of the M3 motorway, a cluster of new warehousing units is about to pop up – part of a wider urban logistics development push being replicated in similar locations on the fringes of towns across the UK to meet growing demand from online retail.

Two of the units under construction at the Logistics City industrial park in the far west of the county of Surrey were purchased in July by LondonMetric Property, a FTSE250-listed real estate investment trust. Over the last few years, LondonMetric has been ramping up its exposure to these types of assets and scaling back its retail property holdings, moving to more than 60% logistics today from roughly 20% in 2013.

That shift comes as traditional bricks-and-mortar stores face the pressures of changing consumer shopping habits and more goods are bought online. In the UK, e-commerce accounted for 16.8% of total retail sales last year, compared with 9.4% on average in Europe, according to Green Street Advisors and ITU data.

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Andrew Jones, LondonMetric
“Retail is a difficult business, and people are working very hard just to stand still,” says Andrew Jones, chief executive at LondonMetric. “What we’ve tried to do at LMP is just try to move with it. It’s not like I woke up one day and all of a sudden had an epiphany that logistics warehouses were doing it for me, it’s just the fact that’s what our customers were telling us: ‘We’ve got too many shops, we really don’t need as many, but our logistics network is not fit for purpose, it was designed in a different era and we have to change that’.”

That means less dependence on large distribution warehouses in remote locations and more of a focus on last-mile logistics centres where the onus is on getting goods to their final destination as quickly and nimbly as possible.

“As online is growing, we’re seeing a big investment in that space,” says Andrew Phipps, head of retail research for Europe, Middle East and Africa at CBRE. “In the UK last year, 30% of logistics space was taken up by online retailers; if you add into that third-party logistics, probably around 60% of logistics space was driven by an expansion of e-commerce. A lot of investors to a certain extent are hedging by buying into logistics to offset their retail portfolios.”

Rental growth potential in the logistics sector is also making development economics attractive, says Peter Papadakos, lead research analyst for continental Europe at Green Street Advisors. “Investors are quite bullish on these smaller locations that are close to the end customer in so far as rents could grow, maybe not quite to retail rents but not that far away,” he says. “So for some retailers, they would value that space as much as they would a shop.”

LondonMetric, for example, has been steadily acquiring smaller warehouses as it seeks to become a market leader in the urban logistics sector. Over the last 18 months, the firm has amassed 38 units, and Jones says he wants to increase that number to 100.

“It’s a very segregated, diverse market, and we think we have the opportunity to become a bit of a consolidator in last-mile, single-let, less-than-100,000-square-foot warehouses – there’s no one big owner of those in the UK,” Jones says. “The leasing is a bit shorter, the tenants are very good, and if one of your tenants leaves, it’s not dividend threatening. And if you buy them in the right location, you often find the intrinsic value of the land is actually higher with an alternative use.”

That means if the unit no longer has demand as a warehouse it could be converted into, say, a car show room or replaced with residential housing, Jones says. “Your use value is very attractive, or what I call sleep-at-night comfort and security,” he adds. “So you’ve got two choices here, you can either sit on the side of the river where the tide is going out and you can paddle against it, or you can get to the other side of the river where the tide is going in and paddle with it. All we’ve done is move our boat from one side of the river to the other.”

Logistics assets

Other investors are betting that logistics assets, particularly those last-mile distribution centres, will perform well, given a scarcity of new developments.

“We’ve had a pretty favourable view of that sector for a while and actually have a bigger exposure there [than retail],” says Jon Rickert, investment director at GAM, whose real estate fund lends directly to commercial property buyers. “There are other drivers around this, given that, as a sector, industrial warehouse and logistics properties have not necessarily had the same level of speculative development as other asset classes.”

Some real estate experts reckon as more money pours into this asset class and the market continues to expand, investors will become more discerning about the different types of logistics operations they are prepared to back.

“Some of those will be high-growth and some will maybe fall out of favour, we still haven’t seen the shaking out of that sector, given that we’ve had so much capital going after it as a sectoral play rather than as a specific type of logistics play,” says Gareth Lewis, a real estate researcher at PwC. “It’s still a relatively new sector, at least in terms of having the spotlight shone on it; it didn’t used to be a particularly sexy sector to be involved in, now it seems to be the hottest one.”

Yet while the interest in logistics is booming and traditional retail falls out of favour, some market watchers reckon investors might be overreacting to the trend because retail property owners can repurpose their assets to meet changing shopping demands.

“I’ve often heard that ‘logistics is the new retail’, but I think that’s overdoing it,” says Brendan Jarvis, head of real estate for Europe, Middle East and Africa at Barclays. “We’re seeing a shift of tenants in the bigger shopping malls that mirrors the demand from consumers. Ten or 15 years ago, consumers would leave shopping centres with more bags than they could carry, but that isn’t always the case now. Of course people still have shopping bags, but more frequently people see shopping centres as a destination in itself. Shopping habits are changing and malls now represent a leisure destination more than they did when they were first built.”

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James Brown, JLL 
That means for shopping centre assets to be successful, they need a diverse mix of tenants beyond retail, such as cinema operators, restaurants and other entertainment offerings. In line with that trend, spending on food and beverage exceeded spending on groceries for the first time ever last year in both the UK and the US as consumers increasingly opted to eat out, says James Brown, head of retail research at property firm JLL.

“Food and beverage has been a huge area of growth over the last 10 years. Those F&B operators in particular have not only satisfied the changing requirements of the shopper but have also helped create an offer within the retail environment that attracts people into the physical space,” he says. “[Eating out] has become more affordable and there’s a broader, more sophisticated offer.”

Duncan Owen, head of real estate at Schroders, says this means two types of physical retail are surviving: ones that offer a great shopping experience and ones that provide convenience.

“Experiences with good leisure attractions that extend dwell time for consumers are really working,” he says. “Convenience is an alternative and would be where you’ve got something that is hyper-convenient, such as a location between your train station and on your way home where it’s just as easy to shop as getting it delivered. Anything in the middle is getting squeezed. And there’s a lot in the middle.”

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Melanie Brown, a real estate research analyst for Europe at UBS, says she thinks about retail assets as a pyramid, with the prime locations at the top and the more challenged locations at the bottom. 

“Towards the fatter end of the pyramid, that’s where we see the greatest impact of online and that’s where we see greater vacancy rates and quite often declining rents,” she says. “But at the top of the pyramid, those locations haven’t really seen a significant impact of online because those types of locations are where the retailers want to be – whether that is high streets, dominant retail parks or large shopping centres – and they can be quite competitive in terms of the rents that retailers are willing to pay in those locations just to be in the right place.”

But it is not just the rise of e-commerce that is hurting the more secondary shopping locations at the bottom of Brown’s pyramid. Sunita Chawla, a partner in law firm Berwin Leighton Paisner’s commercial real estate practice, says that other factors such as a hike in business rates, the depreciation of sterling and government policies such as the increase in the living wage have all increased costs and put pressure on retailers.

In other cases owners have simply neglected or failed to invest in their properties.“Shopping malls actually die,” says Rickert. “I know of one [in the US] where the owner didn’t continue to spend money on capex or work on the tenant mix, and as a result, they lost their anchors and it became a used-car sales facility. I’ve seen some that have become flea markets or bingo parlours. Retail property generally is a living, breathing thing that needs to be actively managed. Landlords who don’t do that will lose out and they will certainly be more impacted by trends like online retailing than others will be. You either adapt or you die.”

In the US, the pain for those at the bottom of the pyramid is even more acute given the scale of floor space dedicated to retail there – roughly five times more per capita than in the UK, according to PwC. Green Street Advisors reckons that over the next decade, as many as a third of all shopping malls in the US could shut down as their main department store tenants – typically a Macy’s, JCPenney or Sears – pull out of struggling locations, hastening those malls’ further decline. So far this year, those three retailers have announced more than 400 department store closures combined.

That uncertainty has heaped pressure on US retail-focused Reits as hedge funds pile in to bet against those stocks. Total returns on retail Reits were -9.9% at the end of July, compared with 6.21% for the broader FTSE NAReit all-equity Reit index. Jay Hatfield, a fund manager at Infracap, which invests in all types of Reits, says the frenzy of short selling has left those stocks undervalued relative to their underlying assets.

“It is a tired short,” he says. “The problem is there are too many hedge funds and not enough short ideas. There might be a few companies that are focused on [lower] quality malls, which would typically be the traditional anchored malls by some of the weaker retailers like a Sears, there could be a couple of companies like that that are just completely in the blast zone that might get into trouble, but for the more diversified companies that have stronger rated malls, we think the trend has been overdone. They have valuable real estate, they’re not going to be shorted down to zero, they’re not going to go bankrupt.”

Other real estate watchers agree with Hatfield’s analysis that not all malls are doomed. “A lot of the noise coming out of the US has been amplified,” says JLL’s Brown. “A lot of the space that had become vacant has been repurposed and re-let, so when we hear about 36 to 40 million of square foot coming back into the market from the department store operators, an awful lot of that is being re-let or reconfigured or repurposed.” 

For Brown a similar hysteria has been dampening demand for secondary retail assets in the UK where all non-prime properties are routinely lumped together.

“The problem we have is that we talk prime versus secondary and the challenge with secondary is that it is everything that is not prime, and that will incorporate secondary which is resilient, fit for purpose and future-proofed, as well as including stock that is fundamentally obsolete,” he says. 

That means shrewd investors can sift through those secondary retail assets and uncover some hidden bargains.“There is still a huge opportunity in that secondary market – it just requires a micro due diligence like never before, but the danger of looking at it in the macro context is that we miss some nuances within that segment,” adds Brown.

Some investors are already doing just that. Jarvis says AIM-listed property firm New River has been successfully acquiring shopping centres that are in good catchment areas but were neglected. It is revamping them with greater convenience and community focus. “This is an example where real estate is not necessarily suffering, rather it’s changing,” Jarvis says. “Real estate has always had to have that resilience and be in the hands of an active owner to make it successful. That hasn’t changed.” For secondary high-street locations, some investors are seeking to buy multiple neighbouring properties to exert more influence when trying to attract potential footfall.

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 Peter Hayes, PGIM 
“Investors pre-crisis have never really been big fans of buying high-street retail,” says Peter Hayes, global head of research at PGIM Real Estate. “One of the reasons for that is how little asset-management potential there is to buy a unit on a high street where you perhaps have no control over the units around you and there aren’t that many you can buy on a prime pitch. There has been more emphasis over the last few years where investors have been looking to buy a portfolio of retail assets that sit together and try to look at how you might have a bit more control.”

Owen at Schroders says private investors have been big buyers of retail units that his firm has been selling. “We’ve sold a lot of high street shops, particularly let to fashion and mobile phone operators and such like, because consumers are just not buying as much from the high street, so you can see the demand going down and the vacancy going up,” he says. “With cheap debt, a lot of private investors have borrowed and bought a lot of shops. It’s not just them, we have sold bits and pieces to institutional investors, but a lot of the demand does come from private investors fuelled by the very low cost of debt.”

Other buyers of non-prime assets have included local authorities who have taken on cheap central government funding to build up a portfolio of retail properties, often to help revitalize their town centres, says Phipps at CBRE.

The online impact


Yet even as those investors battle to turn around the fortunes of underperforming assets, the growth in online shopping is likely to continue challenging traditional retail businesses. Green Street’s Papadakos reckons that online penetration rates could exceed the roughly 25% of sales that is frequently seen as the limit for early adopters of online retail in the UK, if there is another leap forward in technology that makes buying online even easier.

“My sense is that there will be a step change and there will be another acceleration and those penetration rates will move further. Each generation of users is much more comfortable than the previous one. E-commerce will be more encompassing,” he says.

But some market watchers are more sceptical about the potential for internet retailers to take a greater share of total retail sales, given that e-commerce operations are generally more expensive to run than online prices often imply, which means at some point those costs may have to be passed on to consumers.

“Investors are still struggling to understand where this online story is going to end up,” says Hayes. “You’ve seen the growth of online retail by business models that aren’t necessarily generating any returns for their investors, so when will they have to start giving investors money back and change online pricing to reflect that?”

Some previously online-only businesses are also starting to open physical stores, such as eyewear brand Warby Parker and fashion retailer Missguided. Amazon’s acquisition of Whole Foods, a US grocery chain, has also left investors mulling the broader implications for traditional bricks-and-mortar retail.

“The immediate response was that everyone just naturally assumed this would be a negative on retailers in general, but it could mean different things,” says Kin Lee, a mortgage-backed securities fund manager at Angel Oak Capital. “It could be that Amazon is actually telling the world that for it to keep growing it needs a brick-and-mortar presence.”

In the long run, real estate analysts and investors say it is those businesses that can wed both online and physical retail that are likely to emerge as winners from what is just the latest in a long line of retail industry shake ups, suggesting that any obituaries being penned for retail property might be premature.

“We’re starting to see these green shoots emerge of a harmony where online and physical meet in the middle,” says JLL’s Brown. “Physical stores provide a brand presence, which helps promote the online business, so what was seen initially as an out-and-out threat to physical retail is increasingly showing that while it will of course impact on certain requirements for space, it can be used to great effect in the right locations to actually drive retail both online and offline.”