This article is sponsored by PGIM Real Estate
This year, PGIM Real Estate is looking to join a small group of investors considering jumping back into the retail sector – a corner of the market many believe is still in recovery mode from a tumultuous downturn that began even before the pandemic shutdowns.
The real estate investment management business of Prudential Financial has sidestepped this sector for more than a decade. Until now.
“We’ve been very, very bearish on the sector way before others,” says Sebastiano Ferrante, managing director and head of Europe at PGIM. “What’s attracting us now is that we think rents, to a large degree, have bottomed out.”
What are the expectations for the European retail sector in 2024?
Overall, it will be another weak year of low transaction volumes for all asset classes in Europe, though we might see a little bit of pick-up in Q3 and Q4. It depends on how the distressed properties are playing out in actionable deals.
The only money currently out there is opportunistic; this is where the liquidity is. Many investors in equity funds are expecting price cuts across all asset classes, including retail. I expect low transaction volumes in a relatively illiquid market, and possibly some things happening on the recapitalization front – it might not be a transaction in a classical sense, but maybe a recapitalization injection.
What we are seeing on the seller side is that a couple of large investors that have put money into retail, specifically shopping centers, are now divesting for strategic reasons. I would describe it as they have given up. We have seen a couple larger shopping centers in the UK and continental Europe go on the market, and there is always one common denominator: a very big sovereign wealth fund or large-scale global pension scheme as the seller.
Strategic investors basically want to get out of the segment because they lack the confidence that the sector could come back from its underperformance over the past five or six years.
The turning point for shopping centers already started in 2018-19. In the years since, the market has been more liquid, with NOIs dropping, vacancy rates increasing and the disruption in retail playing out in some of the shopping center schemes – even in the better ones.
From a global perspective, you have seen most other asset classes rising from 2019. Even with the covid outbreak, pretty much everybody went up. The only thing that went down consistently during that period was larger shopping centers and retail in general.
There is an element of strong underperformance in the sector and frustration with that asset allocation in general.
What is happening with asking rents that is attracting more investors?
Broadly speaking, rents are why we are starting to look at retail now. In Europe, we have not done major retail investments – not luxury retail, high street, mass market or shopping centers – in the past 10-12 years. We were bearish on the sector way before others.
“Retail was always about change, but that need has accelerated drastically in recent years”
What attracts us now to the sector is that we believe that asking rents have largely bottomed out. Retail has been contracting since 2019 when prime rents started to fall significantly, and values have now adjusted to higher interest rates.
We call it ‘shrinking beautifully,’ or ‘productive destruction,’ which is to say that the sector is shrinking as more and more tenants go into insolvency, occupy smaller spaces and concentrate on better performing locations.
Retail sales may not be increasing, but as successful retail physical space contracts, we see a concentration of good spaces to invest in, those spaces where values have corrected significantly and where prices are low and other players remain overly cautious.
And with rents seeming to drop with every new lease that is signed, the individual shop starts to make money again, increasing their bottom line.
So the strongest retail tenants have survived and are positioned to benefit from economic growth after years of constriction?
Yes, we are seeing this in many markets, in the best schemes and locations. If you take the relationship between profits and rents, it is once again an interesting margin. For real estate investing, that means you are once again buying at a good entry point with potential to start growing rents again.
In addition, I think there is another indicator at play here. E-commerce, which was a major disruptor of retail even before the pandemic, is topping out. In Europe, it is not really growing anymore.
The strongest indicator is the UK market. Online shopping reached a plateau, and traditional retail can now adjust to a more stable e-commerce threat.
In the UK that has really been showing in the past 12-18 months. And even in markets with low penetration, such as the southern periphery in Europe: Spain, Italy, Portugal, it never got beyond a certain point there.
Even with covid, in those markets specifically there seems to be a different culture about shopping. This is part of your entertainment and weekend leisure, to go out shopping, so e-commerce did not take off to the same extent there.
Why has e-commerce stalled in recent months?
Previously, it was always that the infrastructure was not there, there were not enough Amazon facilities. That is not the case, they are all there, they are all bid out. But that market share is not continuing to grow. Some e-commerce providers have even begun scaling back.
With all of it together, the retail rents bottoming out and slowing growth in e-commerce, retail can again be a very good asset class with future growth. But again, only in the best schemes and the best locations. You need to have footfall; you need to be attractive to attract people.
What about consumer spending? What is happening there?
That is another element that is not talked about enough, how consumer habits have changed: where people spend money, what they spend money on. It is not that they are spending less in the major markets, but they are spending differently than before.
There has been a clear shift from fashion and mass-market retail spending to entertainment, to gaming, to consumption of content overall. Netflix did not exist 15 years ago, but people are prioritizing Apple TV or Netflix over some other consumptions if they must choose.
With retail concepts, you need to move with that, you have to make an offering in that space that attracts people into your stores. Retail concepts need to adjust. A classic, four-story, mass-market fashion shop is not as attractive as it once was, so it must adjust. The whole department store business needs to adjust, and that is why we are seeing more department stores going away in recent years.
Retail was always about change, but that need has accelerated drastically in recent years. Retail had been hit by e-commerce destruction, it had been hit by covid and severe shutdowns, and it has been hit by a different generation with different consumption habits. The best retailers have survived, and the places that have survived are interesting opportunities to buy into for investors, because they are showing resilience.
The biggest risk to the retail outlook remains elevated vacancy. But even some of the vacancy issues have been worked through, while construction of new retail space is virtually nonexistent, providing a ceiling to how high vacancies can go in the near term.
While many may be cautious on retail from an investor perspective, we are buying off a low basis with NOI growth that might provide stable cashflows. So now may be the time for investors to take another look at retail. Exit liquidity makes this difficult for value-add strategies, but it may be good for core and focused strategies on the prime segment.
What are the most interesting subsectors in retail today?
The sector we are extremely interested in is the luxury high-street sector. With tourism coming back to global cities, there is huge spending potential in that sector. Those shops offering upscale brands in those areas are doing extremely well. You can see it on the stock market too, in overall sales and profits, but also in the traffic those stores are seeing and the turnover they are making.
But the luxury high-street sector is more challenging because it is so dependent on markets, locations and even the individual street. Decision-making becomes a very selective process of identifying interesting opportunities. The issue with high-street retail is always the same, you never control the full street, you are typically just one landlord out of 20.
If your store is sitting next to a big department store that has gone down and is not going to be sold in four to five years, there is a disruption on your part of the street. That is the way retail works. When there is a disruption, people will not stop. So, if you happen to be sitting on the wrong end of the street, you are sitting on the wrong end, and there is not much to be done at that point.
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