Savills Investment Management on where to find value in European retail

Attractive risk-adjusted returns are still available in European retail real estate if investors can see through negative sentiment and select the right assets, argues Savills Investment Management’s Kiran Patel

This article was sponsored by Savills Investment Management. It appeared in PERE’s Retail Report supplement alongside its July/August 2019 issue.

In May, once-dominant British fashion business Arcadia recently became the latest in a string of high-profile European retailers to run into trouble, putting 18,000 jobs at risk. The widespread perception that many other shopping chains are in a similarly precarious condition has dampened investor enthusiasm for retail real estate. However, Kiran Patel, global CIO and acting global CEO at Savills Investment Management, tells PERE’s Stuart Watson that opportunities remain in the sector for investors prepared to shut their ears to the mood music surrounding it, and look closely at the performance of individual assets.

Q Are conditions for European retailers as tough as the news headlines suggest?

Retailers entering into company voluntary arrangement (CVA) insolvency proceedings are, and will be, an almost daily occurrence in the UK. Until the cost issues facing retailers are resolved, the UK in particular is going to see a decline. Those issues have arisen not just because rents are too high, but business taxation, employee and regulatory costs have also increased. Given these trends, together with the fact that the UK has too much retail space, there has to be consolidation.

Kiran Patel

Some European countries have tighter planning laws, which have provided more protection against new supply, so there has not been the same proliferation of space everywhere. Lease structures also vary. In the UK leases are very landlord-friendly, while in continental Europe they favor the tenant more. The economic costs required to make a retailer’s business viable when operating out of a particular unit have to be in balance, and those costs are a lot higher in the UK. Meanwhile, physical retailing across Europe has suffered from the growth of e-commerce, and not only is the UK more advanced in terms of the uptake of online retailing than most continental markets, but the impact of that trend is greater because the cost of doing business is higher.

E-commerce is not just a one-way bet, though. There is talk of the European Commission introducing a 3 percent online sales tax in 2020 to try to level the playing field, and online retailers spend a lot of money funding free delivery and returns. Few retailers anywhere in Europe can survive as pure bricks-and-mortar operations though. Many are developing e-commerce attachments to their offers.

The beauty of bricks-and-mortar shopping is that where tenants are on turnover leases you can get much more detailed information about how your tenants are operating than you would be able to managing office or industrial property. That allows you to identify properties with positive trends that you do not mind buying into. Demand for physical retail is not dead. It is not rising as fast as e-commerce sales, but it is still growing. Managers need to acquire assets that are resilient to the cost pressures and e-commerce trends facing retailers.

Q How has that difficult environment affected investor attitudes to the sector?

Retail is a hard sell at the moment. The headlines in the UK and US are dominated by retailers going bankrupt and shutting stores, but they do not tell you about the retailers that are doing well and the shops that are opening. That creates an image that stigmatizes the sector. It is easy for investment boards to treat retail as a pariah at the moment, and not touch it under any circumstances.

Some tell us that even though they like the story behind a particular asset they still consider it too risky. They would prefer to do a big multi-level shed in a green field let to an e-commerce operation yielding 4.5 percent than a viable retail property with a cash-on-cash yield of 8 percent. It feels as if when we speak to 20 investors about retail one is interested in continuing the conversation and 10 will just shut the door on us. In contrast, 15 of those investors will say straight away that they have a demand for logistics, despite it being the most competitive and expensive sector at the moment.

It is especially difficult to promote a retail opportunity to investors that do not have a real estate team, but even when they do, and those people accept the argument for making the investment, they still have to sell the idea to their own board. Some real estate teams tell us that while they may really like a particular asset they can just forget it because they only have to utter the word retail to their board and they are marched out of the door.
Retail property fundraising is immensely tough. We have extended the marketing period for our Europe V Retail Fund, but the €100 million we have been able to raise so far is fully invested. As a manager I would rather be in a market where there is less competition. In the retail sector we sometimes see more value on a risk-adjusted basis than we do in the logistics sector, but you have to be picky.

Q So where can investors find value in the retail sector?

Retail formats that have a defined catchment and provide a draw for customers, and which are less sensitive to the cost issues and the spread of e-commerce, will have greater resilience. The obvious ones are value and convenience retail. At the value end of the market, e-commerce is unviable because it costs the retailer so much more to deliver low-value goods than sell them in a store. Budget fashion chain Primark is a classic example of a value retailer that does not have an e-commerce platform. And if a customer wants something here and now, they will not wait 24 hours for delivery, they will go to a nearby convenience store.

That advantage also applies to retail near transport nodes like railway stations, airports and ports – although infrastructure-related retail is very difficult to acquire – and to retail that accompanies public gatherings and events. No property is completely immune to the pressures generated by high costs and e-commerce, but if your tenants are selling low-value or convenience goods on a park where the trading economics make sense for them, they are far more likely to remain viable. As a manager you have to get granular in your analysis.

Meanwhile, at the luxury end of the market retailers use formats like designer outlets to sell discounted products – you do not find a Gucci bag selling on the internet at a 30 or 40 percent discount, for example – so that asset type also offers greater resilience. As a house we are focusing on the resilient sectors within retail. For example, we have recently bought two designer outlet centers at Troyes and Roubaix in France. Formats that require the customer to be physically present will be more robust in the face of e-commerce. The health and beauty business is currently worth $550 billion and is forecast to reach $750 billion by 2024, and more stores of that type opened in Western Europe in 2017 than any other retail outlet.

I believe retail parks are also capable of adaptation to the changing retail landscape, although that process is far from complete at this point. Having large blocks of retail gives you the ability to ‘cut-and-paste’ so you can reduce, expand or evolve particular retail offers according to demand. With most retail it is hard to knock down one part of it and keep another. In a retail park you also have the advantage of being able to put in click-and-collect facilities at the rear of the units.

Q And which sub-asset types will suffer most?

High streets and shopping centers are harder to manage successfully in this environment. You cannot cut off one corner of a shopping center and do something else with it because you have too much space. High street retail can shrink and return to uses like office and residential, but to do that there needs to be demand for those uses. Certain high streets where you have a catchment draw will retain their vitality, while others are dying and they will need to find tenants that fit with a convenience approach and not a destination one. Some town centers are now attracting service-type operators like banks, charities, hairdressers, tattooists and nail parlors, as well as convenience, food and specialty shopping.

However, bricks-and-mortar retailers have faced constantly increasing costs for more than 20 years and at some point rents need to fall, which means certain properties in the retail sector are overvalued. Whether that puts shopping center owners in a really distressed situation depends on how far values decline. Will owners start to breach the loan-to-value levels on their debt covenants? We do not yet know how much debt is secured against this type of real estate, and where the thresholds are, so it is hard to get a grasp of that. Then you have to overlay that with sentiment. If liquidity in the asset class is drying up, what price makes it attractive for buyers? An asset might look like a bargain, but is it really? There may be opportunities to tear some centers down and redevelop them, but values have to drop sufficiently so you are not paying for the building, just the land and the change of use.

Asset case study: Troyes Designer Outlet

Purchased by Savills Investment Management in December 2019 together with a smaller outlet center in Roubaix, Troyes was the first purpose-built designer outlet in continental Europe and remains the largest such scheme in France

Opened: 1995

Vital statistics: More than 100 stores totaling 323,000 square feet of gross lettable area and 1,700 parking spaces

Vendors: Funds managed by US-headquartered asset management group AresManagement Corporation and specialist operator McArthurGlen

Purchasers: A club of French, German and Norwegian institutional investors managed by a Frankfurt-based multi-manager, and Savills Investment Management funds including the Europe V Retail Fund

Debt finance providers: Société Générale and Deutsche Bank-owned asset manager DWS Group

Operator: McArthurGlen will continue to operate the outlet and retains an ownership stake

Future development: Savills Investment Management plans to build a further 69,300 square feet of retail space by infilling the central parking area.