Money can be made by being brave: physical retail is starting to offer some good value

Written By:

Charlie Barke, Knight Frank

16 May 2018

7 minutes to read

Categories: Retail UK

Great as it is to see retail getting so much airtime at the moment, I do not feel that a balanced view is being presented. I am looking for the light at the end of tunnel.

No more doom-and-gloom talk, focussing on those that are losing out at the hands of the on-going retail evolution.  

I am not attempting to deny the scale of the challenge that the retail market faces at present. Times are harder than I can recall and, I gather from those in the business longer than me, today might even outstrip the difficult period of the early 1990’s. 

Despite the ongoing struggles, I do believe we are going through a retail evolution and not a retail extinction. This is a cycle, perhaps of a different size, depth and shape to the previous cycle, but a cycle from which there will be a recovery.

This is not a retail Armageddon, which will culminate in the death of the high street. Bruce Willis and his team need not be called in to save the world from total retail oblivion this time round. 

Firstly, over 80% of our retail spend in the UK is still made purely through our physical stores.  That is nearly £300 billion of purchases and it is this in-store business that still drives the vast bulk of UK retailers’ turnovers.

On top of that, over half of the near 20% of 'online' sales also still use physical stores in their retail journey, be that through click and collect, returns, ordering or despatch.

That means 90%+ of retail sales are made, directly or indirectly, through physical stores. And whilst internet sales are still growing, the rate of growth is slowing, hinting that perhaps online will not cannibalise physical sales any time soon. 

If a property investor rules out retail as an obsolete product, dated in concept and facing a one-way journey to gradual extinction, that investor is drawing a wrong and over-simplified conclusion that will lead to them missing out on what could be one of the most interesting re-investment plays of the next five years. 

Granted, caution and sound advice is needed. The reality is that some retail stock will continue to lose value with a very real threat of becoming obsolete. However, much of our retail space will find its equilibrium, offering an attractive yield off re-based rents and, whilst other sectors peak, will offer an investor a very interesting counter-cyclical play. 

For the doubters out there I have looked at the last two cycles, where there were similar fears over online growth, the death of the high-street and headlines full of retailer adminstrations and CVAs.

Both cycles delivered a hard blow, not dissimilar to today's cruel market. I can even recall members of my team contemplating a career move to the office or industrial sectors – desperate times indeed!

In the late 1990's, as now, some 100+ shopping centres were available “off-market” to any credible buyer willing to put in a sensible offer.  Many of these centres had been marketed and withdrawn, as is the case today.  

One of the principal counter-cyclical buyers were Kevin McGrath’s REIT Asset Management and they mopped up the distressed sales, acquiring around 20 centres at an average yield of close to 8%.

REIT then sold out of these assets at an average yield of 6.75% within just a few years, arguably too soon as the sector continued to boom until 2007. Indeed, most of the assets sold by REIT were traded at least once more in that cycle, with subsequent buyers still making healthy profits as yields, even for very modest assets, were driven down to sub 6%. 

REIT were not alone in making the most of the malaise in the late 1990's.  Charterhouse built a portfolio of 11 schemes over several years.  They exited as a portfolio in 2003 at in excess of £325m, selling at around 30% more than their respective acquisition prices.  

In fact, CIT, the buyer of the Charterhouse package in 2003, still managed to make a significant return, selling on all of these properties again within 3 years, capturing significant capital growth off the back of further yield shift. 

The 2009/10 downturn was shorter and the upside mirrored that (does that bode well for a longer upswing after the current protracted downturn?).

However, despite the short cycle, several savvy buyers got in and out, making significant profits simply by holding for yield shift, rather than by making significant further investment to transform assets.  Some examples of these are provided below:

Data Source: Knight Frank Research

What this latest cycle points to is careful stock selection. Individual deals fared very well but a blanket strategy of just buying the market en masse has left a few investors in difficult positions.

Also, notable from the list above is that schemes are generally at the better end of the market.  Therefore, the best strategy was to buy good value prime stock, rather than chasing double-digit yields.  

I am a firm believer that we will be presented with a similar opportunity in 2018. Whilst some assets need to see a further fall in value before stabilisation (I clarify, some owners/valuers need to acknowledge there has been a further fall in their values), the market is starting to offer some good value, set against historic contexts, other sectors and other geographies.    

Someone will make good money being brave, picking the right stock and then riding the inevitable recovery that the property cycle always brings.  

2018 looks likely to flush out the weak retailers and, whilst few schemes will be immune to NOI adjustment this year, after those weaker operators have been realigned / removed we should be able to get more comfortable on income stability, which then enables us to focus on where good value lies.  

As in 2009/2010, stock selection will be key.  I do not believe it’s only about buying good value prime though.  The strong “community centres” continue to be less affected by the change in consumer shopping habits.

Many of these centres continue to serve a valid purpose and have re-aligned with a reduction in fashion offer. The good assets in this category should offer 8%+ income return and a solid prospect of yield recovery to circa 7% as the market recovers.

Not all readers will share my optimism. There will be plenty of the view “but it’s different this time”, and I agree, it is different this time. However, what is the same is that a) the downside fears are probably overblown and b) someone will make good money being brave, picking the right stock and then riding the inevitable recovery that the property cycle always brings.  

Charlie joined Knight Frank as Partner in 2016, having previously spent 16 years specialising in retail investment. Charlie is Head of Retail Capital Markets, focusing on large shopping centre disposals & acquisitions.

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