Technological and cultural disruptors are forcing a furious pace of change in the retail asset class. Markus Meijer, chief executive of investment manager Meyer Bergman, walks PERE through the process of how an appreciation of the factors underlying that transformation can help to shape a sustainable, modern portfolio in the sector.
PERE: What is the relationship between consumer behavior and investment strategy in the retail asset class?
Markus Meijer: To adopt an occupier-focused approach to investment you always have to get inside the head of retailers to understand where they see growth opportunities in particular locations, segments and channels and how they translate that into their real estate footprint – how many stores they will have in which locations, whether they will be flagships with a full range of merchandizing, or satellite stores in neighborhoods and so on. At the end of the day, it’s always about how the consumer behaves and where and how they consume.
The most important change in consumer behavior is, of course, the shift to spending online. Footfall continues to decline in shopping centers, and even in some city center locations where investors used to be more comfortable because there was significant demand from tourists. Another behavioral factor is the generational shift in expenditure. Younger people tend to spend less on discretionary purchases like clothes. Instead of wanting more stuff they are spending more on experiences: travel, food and drink, hotels and other opportunities for social interaction.
Over the next few years I would not be surprised if even some extremely established locations show signs of weakness. There will probably be a sustained decline in retail rents globally until they find a level when retailers can consistently make money again and new retailers can enter the market. Eventually there will come a point when online retail growth will slow down and the environment will stabilize again, but we still have several years to come when growth will be on the side of online retail while bricks and mortar will take the damage.
PERE: How is that impacting the behavior of tenants?
MM: Retailers that can shift with people’s tastes very quickly and deliver very promptly at an affordable price point will do well, but those that cannot change fast enough will continue to suffer. With the evolution in technology and big data, retailers now capture much more information about their customers, and this informs them to adapt their business model in order to survive and succeed in the new retailing environment.
“Many retailers prefer to have small stores with flexible lease structures so they can change locations quickly if they see their client base shifting”
A few years ago, the conventional wisdom was that retailers would want fewer, bigger stores in more expensive locations with more space to be able to stock all of the merchandize people can buy online. For example, it was said that to cover the UK retailers went from needing 250 stores to 70 stores. Today, however, the number of stores is no longer the crucial point. Wherever they are, retailers don’t want to be paying too much rent, and they don’t want their inventory sitting in big stores in expensive locations when it is much cheaper to keep it in their warehouse.
They also want flexibility. Across the board we see retailers signing shorter leases. They want a lease with a break clause at three years instead of five years, and we have moved far away from the 20-year leases that were once commonplace. They see their stores as a merchandizing tool and an entry point for purchasers, but there is no need for a massive inventory and a big staff in any single store. Many of them prefer to have small stores with flexible lease structures so they can change locations quickly if they see their client base shifting.
PERE: What does that mean for investment managers?
MM: It means hard work. Maybe it was a bit too easy in the past when you could buy a big store, sign a long lease and everybody was happy and comfortable with nothing to do. It is debatable today whether you would rather have a 20-year lease with a struggling retailer whose future may not extend beyond five years, or a shorter lease with an upcoming retailer with strong growth and a cooler brand that is not about to go into administration. It has become more difficult to identify what a strong covenant is. In the office sector WeWork doesn’t give any corporate guarantees and the rent is being paid by their tenants, some of which are start-ups, so there was some discussion of whether there should therefore be a discount on the investment yield where they were the occupier. Now people are more relaxed about it because WeWork is taking a lot of space and it is an extremely valuable company. We are beginning to see the same thing with retail.
It is increasingly becoming a sector where you have to specialize to be able make the right investment decisions. You can no longer just examine the footfall figures before you buy a shopping center or high street shop and then expect it to perform. A successful investment strategy is now about understanding the retailers themselves and which other retailers are in that location, to determine whether you are in a place where the retailer will still be able to afford the rent in future, and if they cannot, whether you will be able to sign up one that can.
It is getting more difficult for investment managers to determine whether they will have a secure income from an asset going forward. In the UK we have seen a number of company voluntary arrangement processes – most recently with House of Fraser – that enable occupiers to rearrange the deals they have with their landlords. Retail landlords will have to be prepared to see more turnover in their occupancy and they will need to focus more on smaller store formats because bigger ones are becoming increasingly difficult to let. Some will have to look at splitting up big units if they can’t find the right retailers for them anymore.
PERE: What should a modern retail portfolio look like?
MM:For us it means a much stronger focus on urban mixed-use where you have a bit of diversification so not all of your income is from retail, but you have offices and residential as well. Even if a tenancy expires you can wait for the right retailer to come along because you still have the income from the offices and housing. Retail rents coming down means that in many mixed-use schemes there is more of a balance in the proportion of the income that comes from shopping and from other sources, which is a good thing from a diversification point of view.
The paradigm of only investing in office, retail or hospitality is changing anyway because the lines between them are becoming increasingly blurred. Most offices are in city center areas so they tend to be on top of retail. Likewise a lot of hotels are combined with retail or residential. It is increasingly difficult for institutions to make a strict distinction between their allocations to different sectors, certainly if you are investing in an urban context and there is more appetite for exposure to cities.
To build a modern retail portfolio you have to understand how the retail business works today and how it might develop. You can’t look back to the analysis and approaches of five or 10 years ago because they just don’t work anymore.
This article was sponsored by Meyer Bergman. It appeared in the Investing in Retail supplement to the July 2018 edition of PERE magazine.