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A timely report by ULI Europe sets out the potential triggers for the required restructuring of Europe’s retail real estate sector. This report becomes even more salient following a rapidly emerging decline in economic sentiment and performance, identified as one of the stronger triggers, due to the COVID-19 (coronavirus) outbreak.

Investors in retail know they face a fundamental rerating of the sector due to the impact of e-commerce, but until recently it was still too early in the process for many to execute changes. Operating income was still holding up while low interest rates were also lessening the pressure on retail owners to sell or restructure.

At the same time, ongoing retailer failures and falling rents meant that owners were not confident about whether levels of rental income from existing schemes would be sustainable, or what volume and type of space were going to be required by retailers going forward.

ULI’s report is based on interviews (before the COVID-19 outbreak) with 24 major investors in the European retail property market. The uncertain outlook they described caused a state of paralysis in the retail real estate investment market as buyers and sellers failed to agree on pricing. The greatest impact has so far been on the United Kingdom due to its relative over-supply of shops, the highest levels of online retailing in Europe, and an upward-only rent review system that has led to unsustainable rent levels.

However, negative investment sentiment has quickly spread to the Continent, with funders holding back on debt and investors uncertain about the impact that the structural change will have on all markets.

“The fact that major structural change is affecting retail means it is much more challenging for investors to find their footing in the market. Investors know that with falling rents—or repurposing to other uses—the value of their assets is likely to be rerated, so it is difficult to make informed decisions about existing assets or future investments at this time. The impact of the coronavirus outbreak on operating income is not yet fully clear, but the pandemic will undoubtedly put further pressure on retail owners and could yet act as the trigger for restructuring,” said Lisette van Doorn, CEO of ULI Europe.

The report identified a couple of triggers that may move the market forward from this stasis, and provide more pricing evidence. The transparency of the listed market means that public companies are under the greatest pressure and the first movements are already starting to be seen. However, even in this part of the industry, so far only a few sales have materialized despite discounts to net asset value often of more than 50 percent.

A decline in the broader economic sentiment and performance was identified as a potentially stronger trigger. While operational performance of retail real estate has been sufficient so far to avoid too much distress in the market, the current lockdown and reduced economic and consumer activity in many countries across Europe might lead to a faster decline in retailer performance and consequent further losses for retail property. Once the situation becomes more stable and clear, this could see more properties coming to market and pricing at a level where higher-risk capital would be prepared to invest.

The report shows that fresh capital such as private equity seeking to capitalize on the evolution so far has struggled to find entry points with few pressures on owners to bring assets to the market at low-enough prices. One major issue, particularly in the United Kingdom, is that private-equity players already have significant exposure to retail after investing heavily in 2013 and 2014. At the time, this was a promising recovery play, but with the emergence of these structural shifts they ended up investing in a period that was the cyclical peak for secondary shopping centers.

The report argues that for centers to be resilient in the future, they must find affordable and sustainable rental levels to bring about a new status quo. The winners in the resulting restructuring are expected to be experience-led dominant shopping centers and strong neighborhood schemes focused on convenience shopping. The problems are to come for the “lost middle”: centers that lack the pull of a destination but are too much effort for the local shoppers.

Despite the uncertainty, many owners of struggling centers have been looking at strategies to revitalize existing retail schemes to preserve value as well as more radical repurposing solutions for others. “There is no universal solution, but there are effective approaches to be taken on a property-by-property basis. Owners can revitalize stronger locations with food and beverage and leisure uses, or look at repurposing for others,” said van Doorn.

The strategies at this stage in the restructuring will be defensive until there is a clear understanding of the winning solutions. While new uses give the possibility to stabilize the assets with more secure (but potentially lower) income streams, it is very hard to calculate the difference in impact on the valuation between doing nothing and taking action now.

Repurposing also opens up positive opportunities to attune space to changing consumer needs, such as by ensuring that places are more mixed use and interweaving community alongside commercial uses for more authentic places. It can help address the growing need for more (affordable) housing and more logistics space.

Cochair of ULI Europe’s Retail and Entertainment Product Council and a partner at Europa Capital, Andy Watson, comments, “As innovation and technology are changing consumer habits—and at great speed—retail landlords and their tenants are running to keep up. This means that maybe more than in any other sector, the Retail and Entertainment Product Council sees a thirst for knowledge in retail property.

“ULI’s Reshaping Retail report responds to that need, pulling together informed and diverse opinions from market leaders in the industry. This innovative ‘thought-starter’ report points to the fundamental rerating of the sector with retail owners now needing to be fluent in other uses as well.”

Watson’s fellow cochair, retail adviser Chris Igwe of Chris Igwe International, stresses the importance of consumer experience: “Online retail can’t compete on experience. A successful place needs to offer buzz, entertainment, an opportunity to chat, variety, things to touch, things to taste, and more. Even in an era of same-day deliveries, only a shop can give you instant gratification. But delivering all of that, making it relevant, and keeping it fresh means active management.

“However, for retailers to be able to deliver on this experience, there needs to be alignment of interest and a mutual understanding between tenants and owners or investors on what constitutes the optimum rent levels that are sustainable in a market that has changed dramatically, especially from a structural perspective.”