Until recently, retail assets have been highly sort after by listed and unlisted property owners, attracted to the highly defensive and predictable cashflows that retail property has typically delivered. But this is now changing and there are suggestions unlisted super funds are looking to down weight their exposure to retail property. In addition, several listed REITs such as Vicinity, Stockland and GPT Group are selling assets with varying degrees of success.The S&P/ASX A-REIT Listed Index has a market capitalisation of circa $112Bn of which approximately 40% accounts for retail assets. These assets cover the full spectrum from large format retail, neighbourhood, sub-regional, regional and the super-regional malls. Given the size and breadth of underlying assets, fund managers and analysts spend considerable time understanding sector changes or trends to support their investment decisions.
The Freehold Australian Property Fund (FAPF) and Freehold A-REIT and Listed Infrastructure Fund (FALIF) currently have a significant underweight position towards the retail asset class, with a strong belief that the changes occurring in retail are structural, not cyclical. Our preference is to own assets that are irreplaceable and dominate their catchment – such as those owned by Scentre Group which is currently trading at a discount of circa 10% below a very realistic NTA. We remain underweight everything else.
So why are we so cautious?
For years retail landlords have had it easy with steady sales growth underpinning fixed escalations in retail rents. If a tenant wanted to leave there was always a replacement. But this is no longer the case, with owners having to work much harder and increasingly offer inducements or incentives to get tenants to commit to their assets. The introduction of offshore retailers has put significant pressure on many domestic retailers – particularly in apparel. Also, the emergence of online retailing continues to grow, wages growth remains anaemic and the consumer is increasingly cost conscious.
In response to these challenges savvy retail shopping centre owners have reacted. They are constantly changing the tenancy mix to cater for changing consumer preferences with an increasing presence of service industries, leisure and al-fresco dining. Retail tenants are also evolving as their margins have come under pressure and occupancy costs are increasing. Supply chain management is improving, store sizes are increasing to allow for reduced staff per square metre and hard decisions are being made on non-profitable stores.
Interestingly, the first significant retail asset sales were announced this week with Vicinity Centres selling $631m of predominantly neighbourhood centres. Not surprisingly, these assets were at a discount of over 5% to the book value (June 2018) they were being carried at, with some of these having already being marked down and ready for sale in the periods preceding.
In our view some of these assets are reasonable - located in catchments with strong demographics and dominant market positions. Much of the market commentary following this transaction has been around the movement in capitalisation rates. To us, this misses the point. This is not a capitalisation rate story BUT is about the sustainability of income these assets can generate over time. Effective rents are currently ‘resetting’ as tenants are unable to afford ‘in place’ terms given their sales growth has failed to keep pace with their fixed growth obligations outlined in their leases.
Now upon lease expiry, tenants are demanding more favourable terms. This ‘resetting’ of leases can take a number of forms. Some landlords are prepared to rebase rents whilst others use incentives such as rent-free periods or capital incentives to prop up face rents and underpin the asset’s valuation. We believe this still has a long way to play out with our biggest concern around sub-regional assets, or assets that do not dominate their trade area.In our view, risk has not been priced correctly and the performance differential between second tier and flagship retail assets will continue to widen. Due to this mis-pricing, we will stick to investing into the highest quality and most productive retail assets, which will be best placed to respond to the structural changes facing today’s retail environment.