Feature Stories | Aug 05 2020
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The pandemic is set to accelerate existing trends for retail shopping malls, with direct effects upon valuations for listed REITs
-Maintaining occupancy levels remains key for landlords
-Online sales forecast to reach 17% by FY24
-Potential new retail concepts to backfill vacancies
By Mark Woodruff
All shopping malls will face headwinds in the post-pandemic ‘new normal’, according to a recent sector study from Morgan Stanley, released before Melbourne/Victoria went into a second hard lockdown.
The medium-term headwinds relate to the shrinking footprint of department stores, increased online shopping and the impact of social distancing. In an analysis of the two biggest retail listed landlords, Scentre Group ((SCG)) and Vicinity Centres ((VCX)), the broker believes rental income could fall -15% to -18% lower than it was before the coronavirus pandemic.
Stockbroker Citi also expects a structural re-set of rents, driving an L-shaped recovery for retail REITs.
After a brief consideration of the evolution of retail malls prior to covid-19, this article will focus on the longer term impacts of the pandemic. Such a shift of focus is expected by Citi, once REITs provide further clarity on the direct impacts of the pandemic in the upcoming August reporting period.
Evolution of retail shopping malls pre covid-19
US department store chains such as J.C. Penney, Sears and Macy’s have all closed down stores in recent years. JC Penney is now in administration.A similar closure of Department Stores (DS) and Discount Department Stores (DDS) locally would not be a surprise. As far back as 2018, Wesfarmers ((WES)) flagged it was going to reduce its store network by around -20% over the next two years, recalls Morgan Stanley.
The two DS chains – Myer Holdings ((MYR)) and David Jones and the three DDS chains, Wesfarmers' Target and K-Mart and Woolworths' ((WOW)) Big W, have a significant presence. Combined they take up around 4.7million sqm, or about 40% of regional/sub-regional retail mall space in Australia.
UBS confirms space rationalisation already was a feature before covid-19 with most (large) retailers selectively opening stores in quality locations, shortening lease terms on renewal and demanding significant rent reductions and/or capital expenditure contributions on renewal. Citi concurs and had been expecting around -10%-15% declines in shopping centre values for some time.
After covid-19, the concern is that retailers may cast an eye over store networks and potentially bring forward store closure plans.
Current status of retail shopping malls
Covid-19 is a further material negative for shopping centres on top of pre-existing structural weakness. As a result, a number of REITs have reported material declines in portfolio values already.
The listed market is pricing in asset value declines of around -35% for malls (i.e. -25% additional to the -10% expected to be reported for June). UBS expects retailers to reduce their store footprints, but key locations remain critical to their businesses.
Specifically, pricing is implying an asset value decline of around -30% for Scentre Group and around -40% for Vicinity Centres (inclusive of the announced valuation declines of -11-13%).
The three REITs currently trading at the largest discounts to Net Tangible Value (NTA) are large-cap retail REITs. Analysts at Macquarie see devaluations to date of -9%, likely driven by softening of income assumptions. Citi does not envy valuers having to form a view on shopping centre values in this environment and notes this is particularly difficult in the absence of any major transactions.
There is scope for near-term tenant sales to be relatively strong. However, due to stimulus payments and recent super withdrawals, this could be both misleading and unsustainable says the broker. A more stable sales trend is required before we can get reasonable clarity on the post pandemic outlook.
The future of shopping malls
Factor No 1: Occupancy;
Listed Australian malls have historically enjoyed 98%-99% occupancy, but that could decline to around 95% says Morgan Stanley, who believes all malls may come under some form of pressure on vacancy, whether it'd be from DS/DDS shrinkage or specialty tenants vacating, leading to higher vacancy across the assets.
The estimate is that around -600,000-700,000sqm of retail space is at risk of shrinkage over the next few years, equating to approximately five years of supply, or -7% of existing regional and sub-regional stock.
Based on comments that around -20% of Target stores could be rationalised, and -15% at Big W, Jones Lang LaSalle forecasts that over the next five years, around -700,000sqm of shopping mall space could become available as a result of DS and DDS giving up space.
A twofold dilemma for landlords is highlighted when considering Wesfarmers' potential rationalisation of Target stores. Target represents around 4.8% of area for retail landlords, but this understates the retailer’s importance as it also contributes to a shopping centre’s foot traffic and mix. Citi believes this is the key reason why landlords are not exiting anchor tenants proactively.
Individual centres will face significant challenges in attempting to replace anchor tenants as foot traffic drivers, and in re-leasing space to alternative tenants. This essentially adds capacity to the market, and shifts negotiating power further in favour of the retailer. Worryingly, Citi notes US malls have experienced weaker occupancy and rents since department store closures accelerated.
One downside scenario put forward by UBS analysts includes the accumulation of vacancies from retailer bankruptcies and lease expiries, as well as elevated incentives and reduced rents. In this scenario retailers are reluctant to commit to longer term deals given high levels of uncertainty.
Retailer profitability currently remains sound. In the absence of vacancy declines, it's unlikely there will be a material decline in rent to further improve profitability of retailers. But this argument founders if there is increased vacancy across the retail portfolio. Therefore, maintaining limited vacancy this year and next is likely to be the main focus for landlords.
Factor no 2: Online Sales;
Retail sales in Australia total around $330bn per year, of which $150bn comes from transactions inside physical stores of shopping centres. According to the Australian Bureau of Statistics (ABS), online turnover made up approximately 7% of retail sales in early 2020 (up from around 3% in mid-2016).
During April/May online sales have jumped to around 12% in response to covid-19, as shoppers altered their behaviour owing to store closures and lockdown requirements. Morgan Stanley believes there’s a chance this figure will normalise at 10%-15%, or at the very least, somewhat above where the trajectory was heading prior to covid-19 (7%+).
UBS expects online (ex-food) sales to increase to approximately 17% by FY24. The uptick in online penetration implies zero growth for in-store sales, even if retail sales normalise towards 3% growth. UBS concludes retailers will respond by rationalising store networks and focussing on investment in online platforms.
If online sales, as a percentage of orders, moves to that 17% forecast, this could imply around -20% store rationalisation of specialty and department stores over the next five years or so. There will be less impact on landlords, given their ability to curate and remix space away from impacted retailers. As a result, a long term rebasing of rents and increased vacancy post covid-19 seems likely.
Of relevance for landlords is the recent feedback to UBS of the high number of customers using retailer’s online platforms in the local country in preference to the ecommerce platforms of such behemoths as Amazon. This is consistent with trading updates from retailers regarding their online businesses and ABS data that illustrate 62% of online sales are through a multi-channel retailer.
The broker believes the performance of retail-exposed REITs from here will depend partly on the outcome of lease negotiations (occupancy and rental levels) and partly on e-commerce penetration rates post the pandemic period.
Obviously not every category of retail can be substituted with the online channel, but if we assume the step-up is indeed a three-year pull-forward of some online volumes, Morgan Stanley estimates the modal shift could take around -5% off rental income for Scentre Group and Vicinity Centres.
Factor no 3: Social Distancing;
If social distancing restrictions (the 4sqm/person rule) continue to play a role in society, landlords would likely be asked to cut rents to ensure those businesses survive, according to Morgan Stanley. This is especially the case when the JobKeeper subsidy ends.
For pure-play mall owners, the potential impact is small, but not immaterial. Food & Beverages makes up around 12% and 10% of rental income for Scentre Group and Vicinity Centres, respectively. If food court and cafe seating have to be cut back by -50%-60% for an extended period of time, then it is possible that landlords will have to provide constant rent relief until the restrictions are lifted.
After all, even when factoring in takeaway sales and non-sit-down sales, evidence suggests operators are losing -25%-50% of customers as a result of around -60% shrinkage in sit-down capacity.
How much can an anchor tenant exit affect shopping mall values?
What are the costs to a shopping centre should they lose an anchor tenant?
Citi analysis concludes that closure of anchor tenant stores generally, and the closure of Target stores specifically, could add to an already significant leasing challenge for retail landlords.
The analysis starts by highlighting that simply comparing rent per square metre misses two important impacts of losing an anchor tenant.
Firstly, the direct costs of re-tenanting. These can include downtime, capital expenditure to re-fit space to the requirements of a new tenant, incentives to entice a new tenant, and potential loss of an area to be let in reconfiguring space or providing adequate access to it.
While all of these would drag on the centre owner’s financial returns, the conclusion drawn is these costs are typically manageable.
The secondary impacts of losing an anchor are indirect. These can include reduced foot traffic, a shift in the centre’s mix or offering to shoppers, and a reduction in demand for space from other tenants.
Unsurprisingly, the indirect impacts are harder to estimate, although with a growing number of anchor stores either shrinking or closing in recent years, we now have a reasonable sample to analyse as potential case studies.
The above graph highlights the relative performance of re-tenanted centres. In the five years leading up to an anchor tenant exit, centres typically underperform by -28%. This represents underperformance of -5.6% per year, meaning the underperformance is similar in magnitude to five years of zero income for the whole centre.
After the re-tenanting exercise is completed, relative performance improves. That is, the centre catches up a portion (around 5%) of the ground lost over the prior five years. This appears to be a false dawn, however, with this gain reversing from year +2 onwards. Overall, Citi estimates that centres undergoing a re-tenanting underperform by -29% over 8 years or -3.7% per year.
Who is driving re-tenanting?
Historically, shopping mall redevelopments have been at the landlord’s discretion. However, in the case of Target store closures, re-tenanting or backfilling is potentially a function of demand not meeting supply.
In the past, when redevelopments have been instigated by landlords, they have timed capital expenditure requirements according to both retailer demand and the sales outlook for each asset. Over the last ten years, these expansions have typically been underpinned by one or multiple anchors, including DS, DDS and supermarkets. The remaining space is tenanted by specialty operators paying higher rents.
Morgan Stanley highlights 35% of tenants (by floor space) that have anchored redevelopments in the last ten-plus years have been Myer, David Jones, or the Discount Department Stores, the very tenants that will be reducing their footprint in the years following covid-19.
As such, a lot of the traditional absorbers of space will no longer be available to soak up the around -700,000sqm that could be freed up in the medium-term. In addition, the growth of marquee international retailers has slowed down.
Who are potential new tenants to fill the void?
While we may ponder who will take up the slack of excess capacity, it should be borne in mind any mooted new retailers from offshore may take time to crystallise, just as retailers like Zara and Uniqlo were prevalent globally long before they entered Australia.
H&M, Uniqlo, and Zara have taken up around 90 tenancies across major shopping centres since 2013, and in the last six years, almost every regional shopping mall redevelopment has been anchored by one or more of these mini-major tenants. Unfortunately, activity appears to have slowed down and this trio cannot be relied upon to be a significant absorber of space vacated by DS and DDS.
However, several new retail concepts, currently seen overseas or only to a limited extent in Australia, could be implemented across various retail malls, points out Morgan Stanley.
The new concepts include:
• Live/work/eat: Libraries, co-working facilities, and urban farming are all concepts that could become more prevalent in shopping centres. Vicinity Centres is replacing Myer at Emporium with a co-working facility, whilst GPT Group has had Space & Co at Rouse Hill for a number of years.
• Not online: Whilst online sales for a lot of apparel/merchandise have increased exponentially during the covid-19 lockdown, there are some concepts that can only be experienced in person. KitKat opened a chocolaterie in Sydney CBD allowing the personalisation of chocolate and an e-sports arena named Fortress Melbourne is now established at Vicinity Centres' Emporium to create a gaming environment.
• Food: Cooking studios inside malls are rather prevalent in Asia. Morgan Stanley acknowledges this may be more popular in areas where residents may not have big kitchens. So perhaps the concept is more relevant for the likes of major malls owned by Scentre Group and Vicinity Centres, which are surrounded by a more dense population, rather than neighbourhood centres in the suburbs.
• Health and wellness: This is more than just gyms. In the US, Life Time Fitness has taken over an old Sears location, with the tenancy spanning 120,000 square feet. It’s a concept that includes a gym, surrounded by cafes and restaurants.
As we reach the August company reporting season, investors have traditionally relied upon very tight consensus earnings and distribution figures from retail exposed REITs, until management withdrew guidance en masse in reaction to covid-19. Now the range is perhaps the widest Morgan Stanley can remember, meaning the consensus outlook is less relevant and stocks are likely to remain volatile at least over the next 12 months.
The key question remains. What is the sustainable level of income for a shopping centre or retail portfolio going forward? Citi does not expect this question to be definitively answered in the short-term, but does expect to have a somewhat clearer picture after the reporting season.
Watch this space.
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