To buy or not to buy retail? That is the question. Or to frame it differently: What is the price at which investors should buy a particular retail property? Being able to solve this puzzle is ever more critical as changing business models, shifting competitive advantages, and emerging proptech and fintech technologies are all poised to further disrupt the retail industry and retail property valuations.
Given the current uncertainty in the retail market, a good way to start is to derive a range of values for a particular property from the lowest price, reflecting reasonably pessimistic performance assumptions, to the highest price, driven by optimistic assumptions. This will generate a range of relevant prices for a prospective investor to consider allowing them to zero-in on what is a reasonable price to pay for a retail asset. As a rule, anything priced at or below an asset’s minimum value is going to be an interesting investment proposition. The more pressing question for investors is how to value a retail asset that is not obviously dominant retail and is not expected to remain retail given its highest and best alternative use (HBAU). Let’s focus on assets of that nature.
Two factors contribute to making a property asset valuable specifically for retail use: its catchment area and surrounding infrastructure; and its physical structure and tenancies. Both elements are valued in relation to competitive properties. The more densely populated, wealthier and faster growing the catchment area, the more valuable any property within it will be for a purely retail-focused use. The better the infrastructure – transport network, telecommunications connections and utility provisions – the greater the retail potential of the asset. But these same characteristics also make a property valuable for non-retail or alternative usage. And an investor can determine their worst-case scenario price for a retail property by estimating its HBAU value in non-retail use. In a strong catchment and infrastructure location, office, logistics, residential, hospitality and other uses can have significant value.
Once the HBAU alternative use and location value of an asset are determined, it can be added to the estimated incremental retail use value (expected income stream from retail usage over the hold term – the term itself another parameter to be estimated) to develop a minimum value – or price – to potential investors. Any asset priced in markets at or below that minimum value is likely to be an interesting investment opportunity.
Let us determine an investor’s value for an asset priced by the market at $100 million. Let’s say 80 percent of the retail price can be recovered in an alternative use for the property (the residual value/location value of the property), perhaps this is under a residential usage. The residual value or HBAU is highly probable – by definition it is estimated as such under the price-to-worst scenario – and it can be discounted back from the point in the analysis at which the property’s use is converted to its HBAU at a low discount rate reflecting that high probability, say 7 percent. This leaves 20 percent of the price in the retail structure and its tenancies – its incremental retail usage value.
How long to invest
So, how does the investor estimate the term of the investment for which the property should continue in retail use? From what point in time should incremental retail use value be discounted back in order to determine its contribution to current value for an investor or how long should the retail rent be modeled to contribute to its estimated minimum value? Under this approach, an investor can tranche retail income by confidence levels or certainty bands.
For example, an investor may feel:
- Confident that the majority of current retail income is sustainable over a short term (say 80 percent of in-place rent for five years);
- Some confidence that the rest of the in-place rent is sustainable for eight years (20 percent for years one to five and 100 percent of the in-place rent for three more years);
- Low confidence for another two years of 100 percent of the in-place rent;
- An unwillingness to ascribe value to the in-place rent beyond 10 years.
The investor could discount their rent expectations as:
- 80 percent of rent for five years at 7 percent – high confidence;
- 20 percent for years one to five and 100 percent for years six to seven at 11 percent – some confidence;
- 100 percent for years nine to 10 at 15 percent – low confidence;
- 0 percent thereafter – very low confidence.
The final step of the approach is to decide which year to terminate the analysis? By combining the discounted value of HBAU with the discounted value of rent over a set of scenarios – year by year – an investor can develop a view as to their expected hold period and how to estimate the minimum value of the investment to themselves. The hold period should be the year that maximizes the total value of the investment in the hands of the investor. Sensitizing the various elements of the analysis allows the investor to consider how optimistic they wish to be regarding pricing for the property over and above its calculated minimum value.
This approach allows an investor to think in a structured way about their views on the:
- Level of confidence in an asset’s location/residual value (HBAU) versus its current usage;
- Expected value of its retail income stream as to levels, term and probability;
- Optimum year to convert from retail usage.
Retail assets may be an attractive investment if you believe in high alternative use value and a reasonable period of time during which you can expect to collect in place retail rents. To make your pricing decision with regards to investing into a retail property, it helps to have a valuation model that allows separate consideration of each major element of that pricing decision and sensitize your price analysis accordingly.