Retail real estate: back on the shopping list

Written By:

Stephen Springham, Knight Frank

07 Jul 2023

9 minutes to read

Categories: Property Sector Retail World Regions UK London

Key Messages

• Total Retail transaction volumes totalled £2.89bn in H1 2023
• H1 2023 volumes up +5% vs H2 2022
• But this metric masks softening markets in most sub-sectors
• H1 2023 volumes down -19% vs H1 2022
• YTDs figures inflated by Foodstores (esp. portfolio deals)
• Stripping out Foodstores, volumes down -43% vs H1 2022 and -24% vs H2 2022.
• Retail Warehousing top performing CRE class in H1 (total return +4.1%)
• Retail Warehousing volumes of £995m in H1 (34% of total)
• Foodstore volumes of £1,071m in H1 (37% of total)
• Shopping Centre volumes more constrained (£352m, 12% of total)
• Encouragingly, buyer pool is increasing (and now includes retailers themselves)
• Investment demand and liquidity are improving
• But FY volumes will be restrained due to low stock levels.

Improving investment demand and increasing liquidity in retail real estate generally, but underwhelming volumes in H1 2023, mainly on account low stock levels. Foodstores the only retail sub-sector to report improved y-o-y volumes in H1, but even this was skewed by a number of portfolio deals. But we are starting to see rental growth.

Retail warehousing not just the best-performing sub-sector in retail H1 but in overall commercial real estate. Within retail warehousing, yields are diverging – polarisation within the market is causing the best to harden, and the rest to soften.

Still very selective demand for larger shopping centre assets, with some £50m+ deals on the table, but most deals are taking place at sub £15m. But the buyer pool is growing and now includes retailers and Local Authorities alongside private investors, property companies and private equity groups.

In the high street, low stock levels are holding back transaction volumes, despite reasonable investment demand. Having repriced yet again following the September 2022 mini-budget, high street yields have hardened 25 bps over H1.

H1 2023 retail investment in a nutshell.

Review of the year so far

As has been well documented in previous Retail Notes, consumer markets have remained largely (and surprisingly) positive despite the many challenges facing the market - ever rising base rates, the US debt ceiling and 19.1% annual food inflation to name but a few. Retail sales values (amount spent) achieved +5.6% year-on-year growth in Q1, reflecting heightened inflation, but year-on-year volumes (number of items purchased) at -3.8% suffered at the hands of the ‘cost of living crisis’ (albeit markedly better than Q4 2022: -6.3%).

There has been very little occupier fallout over the year to date, as we predicted in our Retail Property Market Outlook for 2023. The only major household retailers to go into administration - Paperchase and M&Co - are both ‘repeat offenders’ with chequered histories of private equity ownership and a track record of previous administrations. The impending Wilko CVA (CBRE advising) is being closely monitored by landlords and agents alike and will provide a test-case of the judgements of the Debenhams CVA in 2019 - namely whether landlord can exercise forfeiture and pursue alternative demand where this exists.

Investor sentiment towards the various retail property sectors is largely positive, despite the obvious macro-economic challenges. Furthermore, it continues to improve, with rents and values appearing to have turned a corner and a growing buyer pool across the markets. This is supported by MSCI’s H1 2023 (Jan-May) total return figures showing Retail as the best performing of traditional sectors: Retail +2.90%, Offices -2.40%, Industrial +2.50%, All Property +1.40%.

Retail investment sales have principally been driven by vendors under pressure to dispose and the lack of distress (and thus lack of stock on the market) continues to constrain the transaction volumes, even with the growing weight of capital looking to be deployed. Debt is (selectively) available for all sub-sectors but is typically low leverage and expensive, meaning net initial yields remain elevated.

Retail Warehousing leading the way

Retail’s strong MSCI H1 2023 performance has so far been driven by the buoyant Retail Warehousing market. Total returns for Jan-May 2023 were +4.10%. Evidence of rebased rents, reduced rates liability and low void rates has sparked an increase in institutional activity within the sub-sector, with UK institutions now serving as the principal buyers and accounting for 52% of acquisitions in H1 2023. This improved demand has driven yields downwards over the half year but only for truly prime, well-located product, causing polarisation between prime and secondary to widen. This has created three distinct buyer pools:

1. Institutional Investors (Funds/REITs) - seeking ‘best in class’ assets typically (though not exclusively) within the South East. ESG credentials are becoming of increasing important in this      space.
2. Middle Money (primarily Overseas Investors) - seeking core plus yields of 7.50%+.
3. Leveraged Purchasers – needing yields above 8.50%+ given the cost of debt. Therefore, forced to target secondary assets / weaker geographies.

Foodstore volumes inflated by portfolio deals

The resilience of the Foodstore sub-sector was well documented during the pandemic and preliminary 2022/2023 results for Tesco and Sainsbury’s show they are also weathering the ‘cost of living’ storm, with both reporting Group Sales +5.3%. The sector’s relativity to fluctuating gilt yields has, however, impacted the Foodstore Investment market, with prime yields currently estimated at 5.00% NIY, up 150bps from their 3.50% NIY peak last summer.

Foodstore transaction volumes appear healthy at £1.07bn for the first half, up 255% on H1 2022. However, this includes two trades of the Sainsbury’s Reversion Portfolio (combined £627m). A number of Morrisons-backed investments have been marketed, with Asda also understood to be preparing a sizeable sale and leaseback package. Availability of the ‘superior’ covenants of Tesco and Sainsbury’s has been lower and a clear premium is starting to emerge for the non-private equity owned groups.

Many Foodstore developments are now unviable as a result of build cost inflation and heightened capitalisation rates. Therefore, to enable schemes to come forward, we have witnessed examples of supermarket tenants materially increasing the rent payable. This is leading to signs of rental growth, arguably not seen in the sub-sector for 10 years.

Shopping Centres – a growing buyer pool

Until recently, Shopping Centre investment liquidity has been confined to smaller lot size sales. This year, we have seen a step change with a handful of bigger ticket transactions taking place. Notable activity includes Landsec’s off-market acquisition of the remaining 50% in St David’s, Cardiff (ca. £113m) and the separately-owned Debenhams department store (Knight Frank sold); Frasers’s acquisition of The Mall, Luton (£58m – Knight Frank sold) and Churchill Square, Brighton (under offer – Knight Frank selling). Crucially, these buyers are all using existing cash reserves to acquire these assets, so outside of the few purchasers able to make cash investments of this scale, the cost of debt will mute larger transactions for the foreseeable future.

We have advised on an extensive list of Shopping Centre sales through 2023 so far. Initially, we were surprised by the growing list of prospective buyers, with most trades being taken to bids and multiple proposals received (albeit from a very low base). Small private equity investors, property companies, overseas investors and even occupiers dominated bidder lists and combined to generate reasonable demand in the sub-sector. However, in light of this modest improvement in demand, there is no evidence of pricing improvement with the sub-sector remaining the hunting ground for the opportunist investor.

It is clear that the ongoing economic turmoil, combined with the realities of managing complex retail investments, is slightly reducing the buyer list. Local Authorities, often seen as buyers of last resort, are having to step in once again to secure the future of town centre assets where regeneration is greatly needed. Other, larger investments such as Festival Place, Basingstoke and Highcross, Leicester, have been withdrawn with asset managers appointed to provide interim stability where demand is limited. We expect supply to increase once the owners of these assets (typically lenders with no desire to hold beyond the short term) sense an improvement in the markets.

High Street – high yields, but low stock levels

The investment case for the High Street sub-sector is sound in core markets. Rents and yields have rebased by broadly 33% and 250bps respectively but stock selection remains critical. There is value to be found here but careful consideration needs to be given to pitch, covenant and ERV. Demand for the sub-sector principally stems from domestic and overseas (namely Hong Kong and Israel) property companies and private investors. In the main, these are cash buyers making the most of what they perceive to be a counter cyclical buying opportunity and attractive yields, relative to other sub-sectors and ‘money in the bank’.

Demand in the Outlet sector remains high with investors attracted by favourable consumer shopping trends, the transparency of trade and the ability to curate tenant mix. We expect stronger deal volumes in this specialist market with ongoing processes for J32, Castleford, Livingston Designer Outlet and the London Designer Outlet in Wembley all ongoing and attracting interest from a range of institutional and private equity investors.

Buoyant Retail Warehouse and Foodstore markets and recovering In-Town markets mean that there is liquidity across the breadth of the retail sector, but a lack of stock across all markets is likely to mute total deal volumes for 2023. A stable or improving economic picture will give investors the confidence to push acquisitions and disposals forward. When it will arrive is the big question.

Knight Frank Outlook

The consumer will continue to be resilient and retailer performance to improve as inflation moderates through the second half of the year. We expect occupier fall-out to continue to be minimal as a result.

Rental growth is possible in pockets of the market – this is most applicable to Foodstores and Retail Warehouse, but some In-Town markets could benefit too.

Institutional interest will further shape the Retail Warehouse sector, with the consequent emergence of an ‘ESG premium’ for compliant assets (and conversely some discounting where assets do not fit this criteria).

Foodstore investment demand and the weight of capital targeting the subsector will increase. However, pricing will remain volatile, mirroring the volatility seen in the UK gilt market.

The appeal to a largely private audience of high yields in comparison to ‘cash in the bank’ on offer in High Street assets will put yields under downwards pressure as the year progresses.

Deal volumes to remain low in the Shopping Centre sector as most trades take place at <£15m lot sizes. A handful of larger, £100m+ deals will support year-end totals, but these will still be significantly lower than 10-year averages.

Elevated debt costs to continue to hold back pricing for secondary assets, but availability of debt to improve for better quality assets, driving further polarisation.