Time to take advantage of opportunities in retail real estate debt?
There is little doubt physical retail is going through a generational change. Increased online shopping, together with punitive business rates, minimum wage increases and weak sterling have combined to create a perfect storm across the industry. This has led to the demise of cherished household brands, widespread tenant CVA’s, opportunistic calls for rent reductions and increased pressure on major landlords.
It seems every week there is a new reason to write off retail property and automatically decline investment opportunities in the sector. But has retail been oversold, and has the doom and gloom in the sector led to attractive retail real estate debt opportunities being overlooked?
Today, most major lenders who have been active over the last decade or so are now looking to significantly reduce their retail exposure. Although they appreciate some borrowers have the business plans to successfully reposition retail assets and improve value, their capital and regulatory requirements, loan covenant ratios and a flight to seemingly more attractive sectors means they have little appetite or ability to support such plans. According to JCRA data, lending to UK retail dropped 85% between June 2018 and June 2019.
This has resulted in a vacuum in retail lending, where banks are working hard to de-leverage and borrowers are unable to refinance. Meanwhile, the performance of the underlying assets might be holding up from an income point of view, but valuations have suffered due to widening yields across the sector, resulting in LTV covenant being testing or breached. According to the Cass Commercial Real Estate Lending Survey, in the first half of 2019 there was a 13% increase in covenant breaches that lenders expected to turn to defaults. Many of these were on retail loans, with rising LTV ratios being the most commonly cited reason for breach.
This exodus of finance has created an attractive opportunity for non-bank lenders to step in and support borrowers with credible business plans. Many are capable of repositioning these assets for the future – either as more cyclically insulated retail concepts, or into alternative assets classes.
Here at Rivercrown we see many good retail assets that, despite effective plans to mitigate their risk through diversification, have been overlooked by the market. We are ready to support borrowers with well-considered plans, by providing them with the time and flexibility required to successfully update their space for a more modern world.
2020 has begun with encouraging signs that others in the market also see positives in the sector, with a noticeable increase in retail activity and some interesting new concepts. For example, Ingka Centres, the real estate division of IKEA’s parent company Ingka Group, acquired the Kings Mall Shopping Centre in Hammersmith, and Prologis acquired the Ravenside Retail Park in Edmonton in January. Both are examples of retail assets exchanging from traditional owners (Schroders and M&G respectively) into new hands with innovative strategies.
Given the obvious mitigants to retail and the potential to add value, rather than writing off the whole sector, retail assets deserve to be evaluated on a case by case basis, by looking at multiple metrics to determine if there is a credible value add play. When speaking to borrowers we are taking a detailed analytical approach to understand the repositioning options in each instance. It is not as simple as knocking up a block of flats and hoping for the best, rather we will be analyzing the holistic approach to improving value and mitigating further retail related risks.
Adverse conditions also provide excellent opportunities. Space previously locked into long leases is being freed up. Providing chances to incorporate new office, residential, student accommodation, F&B and leisure, or social amenity space that will enhance returns and boost the remaining retail offer. The future of UK towns and cities also remains distinctly positive, with forecast population growth and infrastructure developments, combined with historic trend increases in consumer spending. All this should support the footfall vitality of many of these schemes long into the future.
That said, there is still an oversupply of retail. Many weaker schemes that don’t obviously benefit from repositioning will need to fall out the system, but this again should improve the fortunes for the natural survivors.
Finally, the new Chancellor is already under pressure from landlords to put physical retail centres on a level playing field with online retailers. Could his first budget see him trigger a more positive outlook through rates re-valuation or increased online taxation?
What is clear is that the current sector dislocation presents an excellent opportunity to support those committed to enhancing value. Lenders prepared to work with borrowers to take this opportunity should benefit from superior risk adjusted returns available through careful stock-picking, detailed underwriting and sound business plans.
Charles Archer is head of Rivercrown's debt investment management team