Investment Trusts

UK Retail: Closed for business?

Physical retail may have changed forever, but opportunities remain
March 2021

Peter Lowe

Director, Fund Manager

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Risk Disclaimer

Capital is at risk. The value of an investment is dependent on the supply and demand for the trust’s shares rather than its underlying assets. The value of the investment will not be the same as the value of the trust’s underlying assets.

The value of property related securities are likely to reflect valuations determined by professional valuers. Such valuations are the opinion of valuers at a particular point in time and are likely to be revised and movements may cause the value of investments and the income from them to fall as well as rise and investors may not get back the amount originally invested. Property and property related assets can sometimes be illiquid. A fund investing in a specific country carries a greater risk than a fund diversified across a range of countries. If markets fall, gearing can magnify the negative impact on performance.

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be

Physical retail is dead. That is a mantra not too difficult to believe going by the news headlines. Store closures, administrations, stretched balance sheets, indebted private equity owners and the shift to online….Rents are down, vacancies are up, net investment weak and yields sailing outwards.

The headlines are true – but they are not the whole story. Retail is not one homogenous asset class, not one single physical market in itself. Shops, supermarkets, shopping centres, retail warehouses and ecommerce sheds, cities versus suburbs, local, convenience and comparison retail versus speciality, leisure and tourist led trade, all are captured under the retail umbrella.

 

Lockdown has changed things…

…particularly the growth of the move to online. However, footfall data still shows a desire to shop in physical premises, despite current drawbacks and risk. Non-essential retailers who could rely on their online platform to preserve turnover have done better than those who are heavily reliant on bricks and mortar only. That online is served by distribution warehouses or trade counters, rather than the stores that we are so familiar with, unnerves both policy makers and at least some of the general public. This structural switch is bringing challenges around land use, employment and taxation, and rightly, given the role that our town centres play in society at large, wider concerns around the future of our cities.

 

There are problems

Mass market and comparison spend products that can be easily selected and sourced online are where we see the primary, ongoing threat. This has been borne out by distress in the mainstream fashion sector, in the dreadful performance of shopping centres over recent years, and also the fall from grace of the department/variety store. Business rates are an issue, which in many cases now exceed the commercial rents payable. With a limited pot for occupancy costs, this has led to rents collapsing relative to property taxes. Rates suspensions during the pandemic have helped, though a more permanent solution is desperately needed. The rumoured online sales tax may not be a silver bullet for the high street with many of our high street anchors likely to be impacted by such a change. John Lewis & Partners, for example, had already moved to c.40% of sales online prior to the pandemic. It has been reported that a reduction in the business rates multiplier by around a third when combined with a 2% sales tax for online, could actually result in increased burden for many brands with a significant physical high street presence.

 

There will be change for property investors

Painful though it might be, rental adjustment should bring some parity. Many retailers continue to see merit in the more traditional occupational model, albeit updated for the modern world, differentiating their brand through presentation, experience and engagement and with smaller, more focused store portfolios. The new approach requires greater flexibility in lease duration and payment terms, perhaps linked more to revenue or profitability via the turnover rent model – something that will require increased transparency from occupiers and will in the short term at least lead to significant pricing challenges for property investors. Engagement, communication and co-operation are paramount right now, particularly where rent collection is concerned. Medium term an alignment on revenues and rents will be key.

 

Grounds for some optimism

Whilst there are many who have had to endure financial hardship as a result of the pandemic, there are others who have benefitted and been in the fortunate position to have accrued savings. It is highly likely that once we are unshackled from the current lockdown and personal freedoms return, retail and leisure spending will improve, in all likelihood, significantly so.

Food & beverage and Hospitality were the sectors hardest hit by lockdown. With the roadmap to opening up now laid out, there is finally some light at the end of the tunnel, with both leasing and corporate activity picking up in anticipation of the easing of restrictions. Meanwhile, the grocery sector has been one of the most obvious beneficiaries over the last 12 months, both in terms of ‘in store’ sales, and of course online penetration rates, with many new segments of the population trialing delivery of fresh produce for the first time. The increased penetration rates for food have been the primary driver for such stellar growth at the overall online retail sales level given the quantum of spend in this category.

There has been a resurgence in local shopping habits, with support for independent retailers allowing suburban locations to outcompete city centres. Retail warehousing, let off the correct rent, where socially distanced car-based shopping is more achievable and where there may well be a prevalence of government mandated ‘essential’ retailers, has fared relatively well. Indeed, such outlets are now forming part of the wider multi-channel platform for many occupiers via their integration in either click & collect, delivery or strategy for returns, the latter still being a particular profitability conundrum for many.

 

There are limitations…

Repurposing as an underwrite is the buzz topic. Redevelopment of obsolete physical structures is all well and good – but what is the appropriate fair value, what are the capital requirements, and what is the timetable for stabilising income in the business plan? Many of the entry points being banded around simply carry an unacceptable level of risk for core, institutional investors – and we remain a little sceptical about the credibility some of the current plans for this wholesale repurposing at current pricing and where ownership is fragmented.

 

…but don’t discount all retail

There are undoubtedly some attention-grabbing yields available in the sector, but they need to be analysed alongside the leasing risk, and importantly the likely longer-term sustainable rental tone for a given location. We would certainly guard against discounting all retail. Indeed, we see some genuine merit in retail warehouse parks, where income is underpinned by residual site value; convenience retail; and in due course we believe parts of the food & beverage market. Our cities are resilient, and wearing my other hat as Manager of the BMO UK Housing Fund, I can see first-hand the work that is being undertaken to ensure our urban spaces offer more in the way of mixed use, live/work environments, something which the UK has not traditionally offered as well as its European counterparts and which should offer support in terms of a captive, local consumer. Partnership will play an even greater role. We are seeing local authorities stepping forward to facilitate development, recognising the existential threat from a collapse in their city centres, fearing a corresponding impact on public finances and civic pride.

 

Final thoughts

With retail pricing having corrected sharply and with the market now yielding far higher than the All Property benchmarks, the challenge for investment managers who hold the sector is to focus on fundamental value, and not to liquidate assets out of fear of association with the retail badge. This is a particular challenge for those in the public markets and certainly true at a time of strongly negative sentiment towards the sector, with illiquidity a major issue for larger lot sizes. Neither must one be seduced by this margin though. Rather, it is paramount to identify those locations and those styles of asset that are fit for purpose, accessible at the right price point and can offer defendable, sustainable income. Importantly, these opportunities do exist.

While we have been large sellers of high street retail over the past five years or so, we have retained selected trade, convenience and warehouse assets that have performed relatively well, offering attractive income alongside defendable residual valuations, in some cases based upon alternative uses. Certain ‘village’-like urban locations will continue to offer merit, as will food-led, convenience and (albeit at rebased rents) experience-focused locations, perhaps linked to leisure, tourism or education as the USP. The retail market is changed forever, but that does not mean that there will not be opportunity.

Risk Disclaimer

Capital is at risk. The value of an investment is dependent on the supply and demand for the trust’s shares rather than its underlying assets. The value of the investment will not be the same as the value of the trust’s underlying assets.

The value of property related securities are likely to reflect valuations determined by professional valuers. Such valuations are the opinion of valuers at a particular point in time and are likely to be revised and movements may cause the value of investments and the income from them to fall as well as rise and investors may not get back the amount originally invested. Property and property related assets can sometimes be illiquid. A fund investing in a specific country carries a greater risk than a fund diversified across a range of countries. If markets fall, gearing can magnify the negative impact on performance.

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be

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