Uncertainty in retail property values in the UK
The UK commercial property market
Uncertainty in retail real estate markets is causing concern and increasing levels of debate. Here in the UK, the methodology and therefore the accuracy of real estate valuations is being challenged. Markets that can best be described as “troubled” are of particular note. The significant slowdown in market activity is causing increasing levels of volatility in the UK retail property market.
In the writer’s opinion, there is a strong case for moving away from the UK centric yield basis of real estate valuation for retail assets and to treat the sector as “trading assets” and value using techniques such as Discounted Cash Flow (“DCF”). This is the approach adopted by mainland Europe and has been the standard in the US for more than 30 years.
This is far from being a parochial issue as 30% of UK commercial real estate (by value) is owned by inward investors (a combination of private individuals, Sovereign Wealth funds, foreign Real Estate investment Trusts and pension funds).
Real estate in the UK has been attractive to investors (both UK and overseas) for more than 40 years as:
- the UK provides longer leases than anywhere else in the world (although the prevailing trend is for leases to become shorter);
- even today the vast majority of leases include upward only rent reviews giving the landlord a guaranteed minimum income.
According to the Investment Property Forum, one of the leading organisations for commercial property owners in UK and Europe, retail property in the UK (as at 2017) makes up c.35% of the value of the commercial property market (a total value of £935bn).
The woes of the High Street
The fate of the UK high street has been well documented in recent years with increasing levels of voids, high profile insolvencies and Creditors’ Voluntary Arrangements (“CVA”s). Among the household names to go into some form of insolvency are Debenhams, LK Bennett, Patisserie Valerie and Mothercare while others, such as Majestic Wines, have announced a change to their business model to significantly reduce their physical presence. As at November 2019 store closures across the UK are up 77% on the whole of 2018.
There are multifarious causes for the prevailing doom and gloom that include:
- online e-commerce (both in terms of increased competition and the cost of providing on line platforms to enable retailers to become e-tailers),
- high street retail is shifting to become more of an advertising vehicle rather than a profit making enterprise leading to more value being ascribed to street frontage rather than store footprint
- balance sheets overweight with debt (usually as a consequence of private equity involvement),
- business rate rises (which are significant in London & the South East post a recent revaluation),
- oversupply (currently 13% of retail units are vacant in the UK – Source: Knight Frank Retail Monitor Q2 2019),
- historic over – expansion (an example being Mothercare, who bought the high street based Early Learning Centre chain, and then shortly thereafter, moved to an “out of town” model”)
- historic non- identification of under -performing stores,
- Inflexibility of leases (upward only rent reviews, restrictive user clauses, difficult alienation provisions etc.),
- inflation in costs in raw materials,
- minimum wage increases,
- under investment (both in terms of the tenants deferring fit out programmes and landlords not regularly refurbishing their assets),
- planning policies that have, historically, favoured out of town retail in favour of the more traditional high street,
- over-complacency and lack of support from Government (despite retail being a major contributor to GDP).
All of the above are factors (to varying degrees) but, sadly, the reader will be able to think of several more.
So where are retail property values?
So against this backdrop, one would have anticipated that the property owning institutions and companies would have been forward facing and would have provided for a re-basing of their retail asset valuations. During 2018 reported retail property values fell by only by 5.3% over the course of 2018 according to CBRE one of the largest of the global surveying firms.
Market commentators were predicting further value falls in the order of 15% to 20% over the course of 2019; the Royal Institution of Chartered Surveyors has recently issued a notification to its Registered Valuers advising of “structural changes in retail property” and to be “aware of the potential for significant changes in value” in retail properties.
At the same time, in light of the uncertainty around valuations generally, the listed property company sector, which includes such heavyweights as British Land and Land Securities, traded at significant (30% +) discounts to Net Asset Value (“NAV”). Intu, a shopping centre specialist owning such prime assets as Lakeside (Thurrock), Metro Centre (Newcastle) and St David’s (Cardiff) saw its share price fall by 45% in the period September 2018 to March 2019 among much market speculation about its ultimate ownership.
The implication was that capital markets didn’t believe the then current pricing of assets and believed that asset values would fall further. Capital markets have, for some time, been challenging tenant mix and the future health of certain retailers.
Then finally, earlier in 2019, landlords realised that the weight of evidence, sentiment and commentary was against them and began to recognise significant down valuations on their retail portfolios. For instance, British Land reduced the value of its retail portfolio by 11.1% in their annual accounts (year end March 2019) and announced a further 10.7% reduction at the half year (September 2019).
Land Securities has down valued its out of town retail portfolio by 11.1% at March 2019 and Intu has announced a 9% fall in like for like rental income over the year to June 2019.
The Valuer’s dilemma
The lethargy in the repricing of retail property is a function of the delicate equilibrium between an institutional landlord (often an incentivised fund manager) and a valuer. Most real estate valuations are evidence based so that if a valuer decides that it is appropriate to argue for a decline in value of a particular asset, he or she will need to back this up with comparable transactions and not rely just on “market sentiment. However, the challenges of the current retail property environment demands change. Values based on transactions of similar properties rather than based on projected future income have become inaccurate or worse invalid. With fewer and fewer transactions, landlords have, traditionally, been able to argue against reductions in valuation as the valuer does not have the back-up to support his position.
Valuers, will look to demonstrate to landlords, declines in rental levels (i.e. instances where rental deals are struck below historical levels), increasing levels of incentives (rent free periods, contributions to tenant’s fit out costs etc.) and a different pricing on the sale of real estate investments (e.g. investments yields that have softened).
The use of historic transaction data inevitably lags changes in the market. When the evidence does present itself the valuer can adopt a more forceful position in defending his lower valuation. However this, inevitably leads to a time lag between the valuers reduced valuation and true market pricing and this appears to be what has happened in the recent round of value reductions.
More weight should be attributed to the DCF method of valuation as this can be used to reflect anticipated changes in the market. DCF is a forward looking approach which seeks more and better support for core assumptions.
As an example let us look at the valuation of shopping centres which, traditionally, have represented an opportunity for risk diversification (due to the large number and variety of tenants). Over the last couple of years, there has been very few transactions to assist the valuer in forming an opinion of the level at which an asset might trade. For instance, in 2014 £5.5bn of shopping centres transacted while in 2018 the figure was just shy of £1bn.
At the same time, equivalent yields have softened (based on sentiment) from 4.5% to 5.5% in the period between May 2018 to September 2019 - a multiplier change from 22.2 to 18.2, a fall of nearly c.18% (at a time when UK Long Term Interest Rates fell from 1.44% to 0.58%). Given the amounts of rents generated at a shopping centre (Intu’s 16 centres generate an average of £25.7m per annum of rent) any yield shift is going to have a significant effect on the valuation. If a valuer miscalls a valuation yield even by 0.25% the ramifications are significant.
One strategy adopted by landlords is to move some of the occupiers on to 100% turnover rents (as is the case with most UK fashion based factory outlet centres) which, arguably, fosters a spirit of partnership with the tenant. However, this means that the valuer has to add being a retail strategist/forecaster to his or her skillset when it comes to contemplating future turnover figures. Given the uncertainty of the income many landlords may face difficulties in obtaining funding for centres from the usually conservative UK banks.
For more secondary high street and shopping centre locations the likelihood is that many of the tenants are paying rents far in excess of current market levels (due to the existence of upward only rent reviews) and will seriously consider going down the CVA route to renegotiate or exit expensive locations.
Generally average prime rents on UK high streets out of London fell by 4.3% in the year to September 2019 (source: Carter Jonas) with significant regional variations. Again a valuer will use rental evidence in performing a rental valuation; however, it is usual for a landlord to want to protect the rental “tone” if he holds multiple assets in a location (such as a shopping centre) and will prefer to grant tenants extended rent free periods or contribute a proportion of their fitting out costs. Dark stores can cause more vacancy as tenants lose faith in a location. A lot of these deals are confidential and the full detail is not made available (sometimes not even to the valuer!); therefore, in “difficult times” the valuer can be valuing off imperfect data.
The retail property market is going through a period of structural change which reflects the changes in the way we shop. Retail property is core to the necessary regeneration of town centres in the UK; this could, perhaps, be better achieved if occupiers and landlords worked in unison rather than adopting the adversarial approach which has been fostered in recent years. This is the principle behind turnover based rents.
The way that retail property is held will change with shorter leases (potentially driven by external factors such as IFRS16 changes in lease accounting), break clauses and turnover rents. These changes may require valuers and their clients to revisit the traditional yield based methodology (which is often a crude, albeit market based, approach) and to give some thought to alternative approaches such as Discounted Cash Flow (“DCF”).
DCF methodology closely models the risks inherent in tenancy and gives the valuer essential tools to project the future income of a centre. It is widely used by the real estate industry in the US and in Europe and would allow for the various value drivers to be considered and modelled rather than rolled up into one crude multiplier.
Perhaps it is time for valuers to have an informed dialogue with their clients and with the various regulators to move toward alternative valuation approaches which are even more accurate, robust and credible than they are now.