The serious challenges facing the UK retail sector should come as no surprise, with many established high street names disappearing or restructuring.
This in turn is creating a rolling crisis in real estate funds investing in high street properties. Bankrupt tenants pay no rents, and even when retailers restructure via Company Voluntary Arrangements (CVAs), they usually aim to pay less.
The troubles have been building for years, as online shopping has siphoned revenues away from physical stores, adding to pressures from a weak UK consumer. High street rents are also comparatively high, when set against the levels in continental Europe and the US.
According to the Centre for Retail Research, approximately 6,000 UK stores shuttered their doors in 2019, more than double the net closures of 2018. And 2020 does not look promising, either.
Real estate investors are well aware of these trends and are showing little interest in retail properties. As a result, retail landlords are left with few options to liquidate assets – even at deeply discounted prices.
For example, a private consortium had the opportunity to buy Birmingham’s Fort Retail Park last November for less than half of what it sold for in 2011 and 30% below asking price. The buyers ended up cancelling the deal over worries about the market.
Banks or other lenders have also been less willing to grant loans for retail properties and are demanding higher margins, another serious setback for a sector accustomed to using relatively high leverage to deliver on expected returns for investors.
All this is having a tremendous impact on retail property values and returns. We estimate in 2019, UK real estate investment trusts (REITs) had to write down the value of shopping centres by 20% and retail parks by 35%. And yet there is little evidence similar devaluations have been reflected in open-ended direct property funds, likely due to thin transaction volumes.
This could be a problem for the many UK investors who own direct property funds, many of which have significant exposure to this strained sector.
Of the major open-ended direct property funds offered to mainstream UK investors, most had 20-40% of assets allocated to retail at the end of the third quarter of 2019, according to financial statements. This exposure was in areas such as high street retail, shopping centres and retail warehouses.
Institutional investors are not much better off. As of the end of the third quarter of 2019, the 37 institutional funds in the MSCI/AREF UK All Balanced Property Fund Index had a quarter of assets invested in retail.
If physical property funds were to witness sharp write-downs due to the present retail carnage, we could be on the precipice of a fourth major investor exodus from open-ended direct property funds in the span of a decade. M&G already announced in early December it would gate its £2.5bn fund, dubiously blaming Brexit, with a side note of retail woes.
M&G issued an update on 28 January, confirming that the fund will stay suspended for the time being, while noting it has so far sold £70m of properties and its retail vacancy rate is below the industry average.
Nevertheless, we believe this is only the tip of the iceberg.
In our view, the FCA must consider the example of the US, where open-ended ‘bricks and mortar’ property vehicles only allow redemptions monthly or quarterly – while daily-dealing open-ended mutual funds have strict limitations on illiquid holdings. Until this happens, we feel further redemption suspensions are inevitable.
If the FCA does not take action, investors may need to reconsider allocations to retail-heavy UK-focused physical property funds.
One credible alternative is to look to property beyond the UK through REITs, particularly with many compelling investment opportunities on offer throughout Europe. In fact, many property companies on the continent are currently trading at double-digit discounts to reported net asset value. We believe REITs are well positioned to help investors, with the ability to easily diversify real estate exposures as well as providing daily underlying liquidity.
Recent economic data in Europe gives us optimism growth will remain positive this year – positioning offices in Oslo, Madrid, Berlin, Paris and Brussels for rising cash flows. We also see favourable prospects for European logistics companies, with online retail sales expected to surpass 12%. This would be a key milestone, at which point we expect to see accelerating demand for logistics space, creating upward pressure on rents.
Of course, if investors vote with their feet in this way, this will only exacerbate UK property funds’ liquidity problem. But if regulators do nothing, this may be inevitable.