Defrosting the Retail Deep Freeze

Written By:

Stephen Springham, Knight Frank

15 Dec 2023

13 minutes to read

Categories: Property Sector Retail World Regions UK London

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Key Messages

• 2023 was a challenging year for real estate investment generally
• But far brighter prospects for 2024
• Retail investment deal volumes of £6.17bn in 2023
• Just -2% down on 2022 volumes
• But significantly lower than 10 yr averages (£7.33bn)
• Record year for foodstore investment (£2,491m)
• Driven by a number of portfolio deals
• Retail warehousing volumes of £1,775m (29% of total)
• Deals subdued by “bid-ask” gaps rather than lack of demand
• Elevated cost of finance has frozen out many shopping centre investors
• But a number of “big ticket” shopping centre deals are waiting in the wings
• The macro-economic picture will improve considerably in 2024
• UK likely to avoid recession, but GDP growth will be pedestrian (+0.4%)
• RPI inflation forecast to ease to 3.1% in 2024
• Reductions in base rate unlikely before H2 2024 (forecast of 4.75% by y-e)
• All retail property expected to achieve total returns of 6.5% in 2024
• Retail rental growth will remain in positive territory, albeit anaemic (+0.8% p.a)
• Investment volumes will increase across all retail subsectors in 2024
• Accordingly, pricing will also tighten
• Shopping centre, high street and retail warehousing yields to compress by -50bps
• Foodstore yields to compress by -25bps to 4.75% by 2024 y-e.

Suspended in the deep freeze. To say that it has not been a vintage year for real estate investment markets generally is something of an understatement. But 2024 promises to be significantly better.

For all that, the Retail sector has actually been an outperformer in 2023, with total deal volumes at £6.17 billion, just 2% lower than FY 2022 and MSCI Total Returns of -4.3% vs All Property at -7.9%. Once the ugly duckling, most of the Retail subsectors are now back in vogue and significant discounts to long-term values present an attractive buying opportunity.

We are hopeful of a swift thawing in the Retail subsectors in 2024, as investors buy into the resilience of the Retail sector, unlocking stronger deal volumes in most of the markets.

General outlook

2024 Macro-economics

Improving headline macro-economics, particularly around consumer metrics (declining inflation, higher wage growth, rising confidence), but lagging effects of fiscal policy could provide a sting in the tail.

The UK economy will avoid recession but forecast growth in GDP in 2024 (+0.4%) is still expected to be slightly lower than in 2023 (+0.6%). We expect RPI inflation to ease significantly to 3.1% on an annualised basis (vs 7.4% in FY 2023). However, reductions in Base Rates are unlikely before H2 2024 at the earliest and we are anticipating rates to be elevated at around 4.75% at 2024 year-end.

Macro and retail economies will continue to be maintained by tight employment markets – we expect to see an increase in the working population of +0.4% and labour supply rising by +0.3%, despite a moderate rise in the unemployment rate to 4.6%. Average earnings growth of +4.4% will be higher than inflation. However, the cashflow effect of tighter monetary policy will continue to build, with a further 1.5m mortgagors due to refinance before the end of 2024 and many homeowners facing large increases in their debt-servicing costs.

Declining inflation will have a pivotal effect on retail sales, rather than prompt a straight rebound. Retail sales value growth will decelerate to +3.5% in 2024 from c.+5.5% in 2023. This will be in line with both long-term (30-year) and 10-year averages of +3.5%. Retail sales volumes will return to positive but marginal growth (+0.5% vs -2.5% in 2023), spearheaded by food (Q1 2024). Non-food is unlikely to return to positive volume growth before H2 2024.

2024 Property Prospects

Positive total returns across all retail subsectors in 2024 – plus a modicum of rental growth across some.

All Retail forecast to achieve total returns of 6.5% in 2024, a significant improvement on the 2023 outturn of just 2.2%. Negative total returns in Central London shops and foodstores will be reversed in 2024 (5.7% and 5.5% respectively), with standard shops (5.6%), retail warehouses (8.8%) and shopping centres (5.9%) likewise all achieving improved returns on 2023.

Improved total returns will be driven more by income return (+5.5%) than capital growth (+1.0%). The capital value growth picture is mixed across the retail sub-sectors, with retail warehouses at one extreme (+2.5%) and shopping centres at the other (-0.6%). The latter should see a return to positive capital growth from 2025 with yield correction possible from Q4 2024.

Longer Term Prospects

Retail to continue delivering the highest income returns of all the mainstream CRE sectors.

Annual average total returns between 2024 and 2027 are forecast to be 7.0%, with 4-year annual average capital increases of +1.5%. Retail’s annual total returns over the four year period will be higher than Offices (6.5%) and only marginally lower than Industrial (7.5%).

Underlying rental growth will continue, but will remain modest (+0.8% per annum 2024 – 2027). Central London retail will be the main outlier to this (+2.3%), with retail warehousing also outperforming the wider retail market (+1.1%).

Income remains one of retail’s main selling points as an asset class. Annual average income returns between 2024 and 2027 are forecast to be 5.4%, higher than offices (5.3%) and industrial (4.5%).

Out with the old…

This has been a challenging year for real estate, with all commercial investment volumes forecast to be down around 50%. However, with Retail volumes totaling £6.17 billion, the sector is an outperformer with investment activity only 2% below FY 2022 and MSCI Total Returns of -4.3% vs All Property at -7.9%, Industrial at -7.2% and Offices at -16.0%.

Investor confidence in the retail occupational outlook is returning to pre-pandemic levels. General consensus suggests that rents have bottomed out given the extensive rebasing exercise of the preceding three years and most are now buying into a stable income position (if not with the prospect of growth) for the foreseeable future.

Overall retail sales value growth at +5.5% this year suggests that most retailers continue to trade well, setting a solid foundation for an improvement in the investment markets. Negative sales volume growth of -3.2% is manageable and there remains a group of high-performing occupiers in both the in-town and out-of-town sectors with particular resilience in the more discretionary footwear (+21% sales value growth / +15% sales volume growth), cosmetics (+11% / +3%) and furniture (+7% / +3%) categories.

Whilst trading conditions for retailers remain more difficult than usual, we are not anticipating further widespread distress to take hold. The Wilko administration process took some by surprise and was against the run of play. Many of the affected stores were swiftly acquired by competing retailers in signs of a more resilient occupational market. Better capitalised groups such as Poundland, B&M, Dunelm and Home Bargains have taken up stores to limit the overall net loss. We provide a detailed assessment of the ongoing occupier evolution in our recently published report - Retail Renaissance 2023, The Price of Change 2.0.

The appeal of an elevated income return is attracting a diverse range of investors into the Retail sector. Total deal volumes at £6.17 billion are only 2% below FY 2022 (although well-supported by a record year for the Foodstore subsector) but well below the 10-year average of £7.33 billion.

Retail Warehousing

Certainly, this attraction remains the case in the highly popular Retail Warehousing and Foodstore sectors, where occupational dynamics (not least a shortage of new supply given build cost inflation) are stronger and an established pool of retailers have begun to expand their portfolios. A small number of active domestic and overseas institutional investors have dominated both of these markets throughout the year. Realty Income Corporation has soaked up an enormous amount of Retail Warehousing space, totalling 43% of the market, the most of any investor by far this year. Others including British Land (which, advised by Knight Frank, acquired Westwood Gateway Retail Park in Thanet at £54.5 million / 8.50% NIY), DTZ Investors and CBRE IM have made selective acquisitions and elsewhere, M&G have upscaled in Two Rivers, Staines buying the 50% share that they already own for £77.5 million / 7.25% NIY.

Demand for Retail Warehousing investments remains strong but deal volumes, totalling £1.78 billion, have been held back this year by the gap between vendor aspirations and market pricing. There is no shortage of active investment requirements for the sector but until valuations correct to a level reflecting the new capital environment, we expect many deals to be held up.

Foodstores

Foodstore deal volumes total a record £2.49 billion this year, largely driven by sizeable portfolios of Asda (£650 million sale & leaseback, acquired by Realty Income Corporation), Morrisons (£115
million, acquired by PIMCO), Sainsbury’s (reversion portfolio at £430 million, acquired by Sainsbury’s) and Waitrose (rumoured to be under offer at £130 million to M&G) superstores. Outside of these big tickets, there is still keen interest from a range of institutional and specialist investors but volumes have been held back by the rising cost of capital meaning yields need to be 6.00%+ for most investors to get comfortable.

The small number of highly successful supermarket operators in the UK creates a sense of rarity around their investments, and this, coupled with long leases, inelastic consumer demand and their lower propensity to close stores makes this a highly popular asset class. We expect funds and specialist investors to continue to stock up on Foodstore investments when these become available, as we outline in our recent report – Foodstores: a Feeding Frenzy.

High Street

Where rents have been rebased, there remains a strong investment case for the in-town retail sectors (which are also seeing a resurgence of demand) especially given their appealing entry yields. High Street units let to robust covenants continue to receive strong interest and most processes result in multiple offers, especially those in top tier “Cathedral Cities” such as Oxford and Cambridge and the London“villages”. Outside of this narrow group of towns and cities, and for more multi-let investments, yields soften as demand originates from a much smaller group of opportunist investors.

High Street liquidity is greatest for smaller lots. A greater pool of buyers in the sub £3 million lot size arena is generating premium prices and is dominated by UK private investors, prop co’s and overseas investors targeting higher returns.

Shopping Centres & Outlets

Shopping Centre performance remains intensely polarised between larger, destinational assets and right-sized convenience centres and, at the other end of the scale, centres that are proving to be no longer fit for purpose. There is growing evidence to support this outperformance with footfall, retailer sales and leasing data showing a migration of shoppers and occupiers to bigger, better assets. With this, we have seen a number of vendors begin to test the market with larger sales. Bear in mind that yields for even the best stock in this market are now 8.00-10.00%, signalled by the completion of Abrdn’s bellweather sale at Churchill Square, Brighton at £143 million / 9.00% NIY (Knight Frank advised the vendor). This relative discount against more keenly-priced sectors is the principal driver of demand in the sub-sector.

Sales at Centre:MK, Milton Keynes (50%, £150 million), Liverpool One (£350 million), Union Square, Aberdeen (£120 million) and Meadowhall, Sheffield (£850 million but with a £500 million securitisation attached to the asset so really an equity cheque of £250 million) would drastically increase the total deal volume and average lot size for 2024 if these sales are concluded. We understand there are a handful of buyers engaged in each of these processes in hopeful news for the sector.

Aside from these larger sales, there remains an adequate market for local, convenience centres and a number of investors have taken advantage of the quieter markets to each pick up a handful of these centres. M Core (which includes LCP and Evolve Estates) has amassed a sizeable portfolio of local and district centres and other investors such as the Gluck Group, Martin Property Group and Midos have also acquired a handful of assets.

The specialist Designer Outlet market continues to attract investor attention, with five separate transactions totalling £140.5 million this year (included within our Shopping Centre deal volume total) and two others totalling £160 million under negotiation or in the market. The top handful are all within institutional / long-term ownership and are unlikely to trade in the near future. The middle section transact infrequently, creating a sense of rarity, and appeal to investors such as Patron Capital, Ares and Frasers PLC who have all made acquisitions in this space. We expect these assets to continue to appeal with further sales to come next year, albeit with the need for a discount to longer-term, fixed income given the flexible nature of their occupancy.

We expect shopping centre deal volumes, totalling £1.22 billion for 2023, to remain subdued for the foreseeable future. The heightened cost of finance has proven to be prohibitive, even in the higher-yielding in-town retail subsectors where there is more headroom for debt. With margins of 300-400bps over SONIA (5-year swaps currently 4.20% at the time of writing), markets that are reliant on the range of US-based private equity investors have largely ground to a halt.

…and in with the new

We are confident that Q4 2023 will represent the low point for investment demand into the retail sectors, and we expect deal volumes to recover in 2024. Whilst not a ground-breaking forecast given the global expectation that most major economies’ rate-rising cycles have reached their peak, it feels brave to make any sweeping prognoses in the current geopolitical climate.

2024 Sector Predictions

A more stable economic picture will support the appeal of most Retail subsectors' relative discount to the rest of the market. Deal volumes will recover, signalling the start of the next recovery period.

Retail Warehousing – the popularity of this sector will prevail as institutions and specialists continue their acquisition sprees. An improvement in pricing in this market could see some existing owners move to “profit taking” and supply should increase through the year.

Foodstores – the feeding frenzy will continue in one of the strongest sectors in the market. We expect to see more portfolio deals as the leveraged owners of Morrisons and Asda seek to release capital from their owned estates. These will be readily soaked up by institutions and specialists keen to add to their portfolios.

Shopping Centres – larger deals are waiting in the wings so deal volumes will surely increase from this year’s very low base. Confidence in a steady reduction in Base Rates should attract leveraged investors back to the market but yield recovery is likely to wait until Q4 2024.

High Street – pricing for better assets will continue to stabilise and the buyer pool will evolve to move away from opportunists to more committed investors buying into the longevity of well-let investments. Properties reliant on leisure income will be more affected in another challenging year for this sector.

In summary

2023 was challenging, but not as dire as many were predicting this time last year. Recession seemed a certainty back then, but it hasn’t materialised and seems increasingly unlikely to happen. As we predicted, the Retail market has largely ridden out the storm, helped by a surprisingly resilient consumer market which has often defied the “cost of living crisis” narrative. But retail property investment markets have laboured against a backdrop of recessionary fears, Base Rate rises, elevated inflation and heightened cost of finance.

The macro-economic outlook for 2024 is materially better and this should lead to some thawing in real estate investment markets and greater convergence with generally resilient retail occupational markets. But macro-economic recovery will be slow, inflation will only recede very gradually and interest rate rises are only likely to occur in the second half of the year.

Retail defrosting from its deep freeze. A thawing rather than a complete meltdown.

A Merry Christmas and (hopefully prosperous / deal-laden) New Year from the Knight Frank Retail Team.