With a consumer recession ahead and retailers’ costs also rising, external headwinds may temper occupational performance going forward
Consumer trends
With both consumer and retailers’ costs rising, external headwinds may temper occupational performance going forward
As the Office for Budget Responsibility pointed out in the Spring Statement, UK households are facing a decline in real disposable incomes on a scale that hasn’t been seen since the Second World War. There can be no doubt that this will negatively affect spending behaviour at a time when retailers are also facing dramatic rises in their costs.
The fall in real incomes currently being experienced is not just about the high inflation occurring due to Covid reopening and Ukraine, but also due to a rising tax burden due to the National Insurance increase and the freezing of income tax thresholds.
While UK consumers came out of the Covid period with higher than normal levels of savings, the household saving ratio has already fallen below its pre-crisis level, and the fact that the higher levels of savings were concentrated in higher-earning families leaves middle- and low-income households with little or no cushion against rising prices.
We expect that Consumer Price Index (CPI) will peak at just under 9% in Q2 2022, and be back below the 2% target by late 2023. Some of the coming pain will also be offset by stronger wage inflation, though this will not be enough to protect the retail economy from a period of falling real incomes and the inevitable knock-on effect that this will have on consumer spending.
The chart below highlights how household savings reduced to their lowest post-pandemic monthly levels in December 2021 in line with an increase in spend in the lead up to Christmas. However, GfK’s consumer confidence index has reported month-on-month declines since December, in line with high inflation and rising living costs. GfK’s personal financial situation outlook index dropped 12 points in February 2022, reporting its lowest level since March 2020. Meanwhile, the climate for major purchases index fell 5 points to -15, indicating a more cautious approach to spending again from consumers. Oxford Economics is forecasting that consumer spending will fall quarter on quarter through the remainder of this year, a recession in all but name.
However, things will improve as energy prices start to fall in 2023 and the state benefits also rise sharply due to their linkage to inflation. The planned 1p cut in the basic rate of income tax in April 2024 will also mean that the consumer recession is comparatively short and shallow.
Because poorer households tend to spend a higher proportion of their incomes on food, fuel and energy, the pain will definitely be felt harder in some parts of the country more than in others, and this could mean that discounters (who have fared very well in previous downturns), might not be so insulated this time around. That having been said, the latest Kantar data shows that Aldi and Lidl have continued to take market share from their mid-market rivals, which indicates that some trading down is already taking place in terms of family food spending choices.
What people cut back on in hard times is a fairly well-rehearsed story, with spending on discretionary items and bigger-ticket items likely to see the largest falls. While bigger-ticket household items such as carpets, furniture and white goods have had a good run recently, on the back of a strong last few years in the housing market, we expect spending on these items to fall back in 2022.
Leisure spending is arguably the most discretionary area of household spending, and is often not recognised as the single largest. The ONS Living Costs and Food Survey suggests that spending on recreation, culture, restaurants and hotels accounts for 21.9% of a typical household’s spending, far in excess of housing (13.6%) and transport (13.7%). However, past downturns have shown us that people do not cut back on leisure or pleasure as much as they could, with the desire for a treat in difficult times meaning that spending in some segments holds up better than might have been expected. This time around, we expect spend on eating and drinking out to fall slightly as people treat themselves to home-delivered food and supermarket-bought alcohol.
Clothing and footwear typically account for only around 4% of family spending, and thus while cutbacks are likely in this segment, they will not have a huge impact on how much money people are saving or diverting to less discretionary spend. However, the latest ONS data suggests that clothing and footwear prices are 8.9% higher than they were a year ago, which indicates that retailers are being quicker to pass on rising costs to the consumer than they have been in previous periods of high inflation.
One area that might prove more defensive is DIY, with Kingfisher’s and Wickes’ recent statements appearing confident that people will carry on spending on their homes, and there is definitely some evidence from past downturns that DIY spend actually increases as people become more cost-conscious.
The speed at which some retailers appear to be passing costs on to consumers is a clear sign that cost pressures in retail, manufacturing and distribution are just as (if not more) significant than they are in household budgets.
We should not forget that companies do not benefit from an energy price cap, so the dramatic rise in gas bills is already being felt in retail stores and schemes across the country. Added to this is a similarly large increase in the price of diesel, and rises in the operating costs of the retailers who supply shops with their products.
Staff costs will also be a challenge, with workers and unions demanding that wages rise in line with inflation, and this was the single largest area of cost increase that was highlighted in Next’s recent trading statement. Next also made the point that it had made significant reductions in property costs in recent years, with an average rent reduction of 44% on 49 stores. Kingfisher echoed this view, with an average rent reduction of 20% last year on those stores where leases were renegotiated.
While the property cost savings alone will not be enough to fully insulate retailers from margin erosion, they will help. This means that we may see some equally forceful negotiations in 2022 across the retail market as a whole. However, the strong appetite for new deals we have seen in the retail warehouse market already in 2022, coupled with analysis of the deals Savills has in the pipeline, suggest by year end we will return to rental growth, albeit at a slightly more modest improvement than the 10.3% we saw in 2021 (see Occupational market, below).
Looking forward, what parts of consumer discretionary spend are likely to be the most exposed to this inflation/ energy cost squeeze? One way to answer this is to look at historical spending trends during previous high inflation periods where other background elements, such as consumer confidence, GDP and unemployment rate were broadly similar. This is easier said than done considering that we have not experienced this degree of inflation in recent history. However, we did see significant increases in household energy costs in 2008 and 2012 (+19% and +13% in nominal terms, respectively) at a time when consumer confidence was at an all-time low, albeit annual RPI inflation was less than half that of current levels at 4.0% and 3.2%, respectively. So, what did consumers cut back on in 2008 and 2012?
There are a number of differences in spending trends across these two years. For example, more parts of consumer spending reported declines in real terms in 2008 than in 2012. There were also differences in those categories that reported declines; in 2008 spending on out-patient services saw the largest fall (-10.5%) whereas, in 2012, it grew 5.3% in real terms. While there were differences, there were segments that reported declines in both years. It is, therefore, logical to assume it is these segments that are likely to be the most exposed to the current inflation squeeze. These include spending on household furnishing, household equipment and other housing expenditure, which fell in 2008 and 2012 by 6.4% and 1.1%, respectively. Likewise, spend on food shopping, financial services (excl. insurance) and eating out also saw declines in both 2008 and 2012.
Despite the positivity from the DIY operators who are confident that people will carry on spending on their homes and point to DIY spend actually increasing during previous downturns, other household purchases, such as big-ticket household furnishings, may conversely see a reduction in discretionary spend as evidenced by previous inflation squeezes. It may well be sensible not to therefore tar all bulky goods operators in the retail warehouse market with the same brush as we enter a period of rising inflation. Some may well see sales fall, particularly those that sell big-ticket items; however, some will continue to see their fortunes remain elevated for some time yet – the volume of housing transactions and home improvement planning applications remain well above pre-Covid-19 levels for the time being. Appetite, therefore, remains to improve upon their living surroundings, particularly from the more affluent consumers who are perhaps better insulated from the rise in inflation.
Occupational market
Retailer performance has been strong, driven by strong acquisition activity, falling vacancy and rental increases; however, ESG improvements still need to be met
Any regular consumer of this Spotlight will know that as a house, Savills has been singing the praises of the retail warehouse sector for some time. Previous issues have highlighted how well the sector has adapted to the challenges it has faced, most notably the growth of e-commerce and, more recently, the resilience it has shown in response to the pandemic. Despite these challenges, retailer performance and covenant strength remain strong in the sector and, as a result, it has all but completed the rebasing of rents, therefore standing out positively, particularly when benchmarked against shopping centres and high streets, which still have some way to go to address any rental encumbrance.
Investment volumes in the retail warehouse sector reached £3.76bn in 2021. That is the most active the market has been since 2015 and the fourth-highest turnover of the last 21 years. This begs the question, what has been happening in the occupational sector to stimulate such interest in the investment market and, whether or not this outperformance will be sustained going forward? Once again, the retail market is facing a number of headwinds to which the retail warehouse sector is not immune. The rising cost of living, building materials and energy will all play their part in constricting occupational performance going forward. Inevitably some retailers will undoubtedly fare better than others.
UK weekly footfall by sector highlights continued consumer preference towards retail warehousing
As we emerge from the pandemic, it is clear that what made retail parks appealing to consumers at their inception – as well as during the pandemic when social distancing was a key part of the public’s consciousness – is what remains key to their continued success. Namely convenient, easily accessible, highly visible roadside locations with large units and adjacent free parking. Alongside this, there is an ever-increasing propensity for landlords to include restaurants, convenience F&B and the associated facilities on their retail warehouse schemes, which is a very deliberate and successful attempt to increase shopper dwell time across the sector. As a result, we have seen an explosion in the take-up and space requirements of a number of F&B operators, including but not limited to Costa Coffee, Starbucks, Tim Hortons, Five Guys and Greggs (see The 20 most acquisitive retailer and leisure operators in 2020).
Consequently, we have seen retail park footfall continue to outperform the rest of the UK retail market. Indeed, in April last year, retail parks saw footfall in excess of 2019 levels for the first time since the onset of the pandemic (+2.0%); at one point in mid-June 2021, footfall on retail parks was at near parity, as low as -0.2% below the same levels pre-pandemic. In the week running up to Christmas footfall once again peaked, reaching 5.1% above the levels seen in 2019. Footfall on the high street, however, has at best been -7.7% lower than that on retail parks since the onset of the pandemic, at its worst as much as -43.6%. Shopping centres has fared even worse, at best -13.0% below retail park performance but as much as -47.7% below in April 2021.
In the most recent weekly figures (w.c. 23/04/22), high street footfall was down -13.3% compared to 2019 equivalent levels while shopping centre footfall recorded a -18.6% gap. Retail parks continued to outperform, with footfall levels only -5.6% below 2019 levels.
Strong acquisition keeps vacancy low in the retail warehouse market
One of the most positive trends we have seen in the retail warehouse market of late is the appetite for new units from retail and leisure operators across all product categories. 2021 saw the number of new openings match exactly with that seen in 2019 at 1,021, the highest recorded in the eleven years that Savills has been capturing this data and far in excess of the 855-unit average of that period. This pattern of new openings looks set to continue with 433 new openings agreed by the end of Q1 this year. As the chart, below, demonstrates, this should have an even greater positive downward influence on the current vacancy rate over the remainder of the year – typically and unsurprisingly, previous years have demonstrated a strong correlation between high numbers of store openings and low vacancy in the sector.
In terms of the brands, it is the value-oriented operators that continue to top the charts of the most acquisitive retail and leisure operators. Overall, value-orientated operators accounted for 44% of all new openings in 2021 (54% – more than half – in terms of floorspace). Of the top 20 brands highlighted in the table below, value retailers account for two thirds (65%) in terms of new units and 83% in terms of new space in 2021.
Lidl, Aldi, Home Bargains, B&M, Iceland/The Food Warehouse, Farmfoods and The Range are all examples of value-orientated retailers that have been the most acquisitive over the last three years. Lidl, of course, remains top of the leader board, both in terms of the number of new units and additional space they have taken in that time. So far this year, it has acquired as many as 20 new units already, equating to c.393,000 sq ft of additional floorspace, with an average store size of 21,800 sq ft. Aldi is not far behind with eleven new stores in Q1, equating to 227,100 sq ft of additional floorspace, with an average store size of 21,900 sq ft. With both operators stating they are each looking for around 50 stores each per annum for the next three years at least, the growth pattern of the discount grocers, in particular, looks set to continue.
This strong pattern of portfolio growth for a number of retail operators is no accident, as ultimately, the fundamentals of the sector remain strong. In addition to the factors already discussed that make retail parks appealing from a consumer perspective, the ease for click & collect fulfilment, lower service charge, good size and layout of units, sustained footfall from foodstore anchors, in particular, and of course, more competitive rents, are all additional factors that help to drive the above-average retailer acquisition activity we have seen both pre- and post-lockdown.
What is comforting is the appetite for growth is coming from across the whole sector and covers a number of different product categories. Those retailers highlighted in yellow in the table above are new entrants that have moved into the top 20 most acquisitive brands versus the previous year. It highlights how there are plenty more operators than just the discounters looking for space, and they are doing so across all formats.
Notable examples of retailers outside the top 20 that took space in 2021 include Easy Bathrooms (10 units, 52,500 sq ft), B&Q (3 units, 36,800 sq ft), Sofology (7 units, 94,900 sq ft), Hobbycraft (6 units, 56,500 sq ft), Tapi (5 units, 50,500 sq ft), Wren Kitchens (4 units, 45,700 sq ft), and Pets at Home (6 units, 36,500 sq ft). Many of these brands are considered more traditional retail park operators, but all have taken significant space over the last twelve months, highlighting the breadth of both occupiers looking for space and the formats they require.
The sector‘s strong acquisition activity has subsequently helped to drive vacancy downwards, as seen in ‘Out-of-town new store openings versus vacancy‘. Undoubtedly, such strong retailer acquisitions have in part been driven by the structural change in rent we have seen in retail over the last few years, where the most active brands, particularly the discount operators, have been keen to take space on more affordable terms. Out-of-town vacancy in the retail warehouse sector did creep up to 6.1% by the end of 2021, an increase of 0.6% versus the same time the previous year, however, half of that (0.3% of the market as a whole) was as a result of the failure of Arcadia at the end of 2020 which resulted in overnight voids of 77 units or 1.1m sq ft of fashion space across the Outfit, Topshop, Topman, Burton, Dorothy Perkins and Miss Selfridge brands.
Nevertheless, by January of this year, it had fallen to 5.9% and by the end of Q1, it was at its current level of 5.4%. Vacancy in the sector certainly remains robust, particularly in comparison to other retail asset classes. LDC currently forecasts vacancy for the whole retail and leisure sector at 14.1%, with shopping centres at 19.0% and the high street at 14.1%. The loss of the Arcadia brands at the end of 2020, as well as the disappearance of Debenhams department stores around the same time, are both examples where the impact on the high street and shopping centre markets has been greater than is true out of town.
Both 2019 and 2021 were record years in terms of new openings, with 1,021 new stores in each. Both these years saw additional floorspace of c.6m sq ft (10m sq ft of new openings, minus 4m sq ft of closures). Applying that figure to 2021 and analysing the deals in the market that are currently under offer, we could see vacancy fall to as low as 4.4% in the market by year end. Furthermore, it is also comforting to know that not all regions perform equally in the UK in terms of vacancy, with rates generally lower in the south, particularly the South East. This is significant as this is the largest market by some distance at nearly 113m sq ft (see chart below).
A return to rental growth in the retail warehouse market
With the appetite for new stores openings showing no sign of slowing down, we inevitably saw sustained rental growth in 2021, a position it seemed we were in back in Q1 2020, before the impact of the pandemic delayed proceedings and the inevitable questions of further rental decline and even operator survival began to emerge.
Last year saw a net effective rental increase of 10.3% on average, on the deals Savills was involved in. There is now real optimism surrounding the potential for continued rental growth going forward, supported by the consideration that only 26% of tenants across retail and shopping parks have a lease expiry sometime in the next three years. The evidence suggests we are close to the end of the lease expiry cliff in the retail warehouse sector, having renegotiated most of the large, arguably unsustainable, rental agreements that were signed 10 to 15 years ago.
One recent but important development to be aware of in terms of the recent rental growth in the retail warehouse sector is the distinction in performance when we analyse by size of unit. As figure 7 shows, by far and away the strongest performance was in those units under 2,500 sq ft in the growth we saw in 2021. Net effective rental growth in convenience F&B was particularly strong last year, which is why units at this format saw net effective rental growth of 26.0% in 2021, taking the average to £33.83 psf.
Looking at the data on our drive-to and drive-thru deals in isolation, average net effective rents are even higher at over £40 psf. This is simply down to the volume of occupiers competing for space at this format. The likes of Costa Coffee and Starbucks are still as acquisitive as they have been in recent years however, we are also seeing a number of new entrants to this market, all vying for space in this area, including Greggs, Tim Horton’s and Five Guys. ’The 20 most acquisitive retailer and leisure operators in 2020’ clearly demonstrates the pattern of growth in this sector is likely to continue as we see continue to see appetite for acquisitions at this format into Q1 2022.
In fact, performance at this format has seen such strong rental growth that we have removed them from the results highlighted in the charts below in order to ascertain a truer picture of performance across the rest of the retail warehouse sector collectively. The charts below is therefore annual net effective rental performance across the sector with units under 2,500 sq ft removed.
Historically, when vacancy/supply in the market has been at its lowest, net effective rents have reached their highest. With vacancy beginning to fall as we move through 2022, the sector could be forgiven for assuming rents may begin to creep northward at a similar rate. Particularly as many of the value-orientated retailers snap up the best of the vacant Arcadia stores and a number of longer-term voids also return to the market – particularly those where alterations have taken longer than usual to pass through the planning process.
Retailer performance has been positive in the retail warehouse sector
Retailer acquisition activity and falling vacancy is important, but it is, of course, part of a bigger picture that includes retailer performance. It makes sense that the pleasing statistics we have seen in these first two key performance indicators, suggest that operator financial results have also been positive for the most part. The chart, below, highlights the consumer spend figures for Barclaycard, and distinctly shows that those sectors pertinent to the out-of-town market – namely grocery, household goods, DIY, discount stores and sports and outdoor retailers – are those sectors in the last few years that have seen positive average spend growth versus 2019. This demonstrates just how resilient the retail warehouse market has proven to be despite the pandemic, showing itself to be well placed and savvy enough to deal with any future headwinds that the market is currently dealing with.
As we eluded to in our previous Spotlight in December last year, some of this performance has come as a result of the unprecedented increase in housing transactions over the last few years – 2020 seeing the most transactions in the UK housing market since 2007. What has certainly proven to be a feather in the cap for retail warehousing from an occupational standpoint, is the relationship between residential sales value and the positive sales growth for the sector’s traditional bulky goods and DIY operators.
The stamp duty land tax holiday introduced by the government in July 2020 ran until September 2021 and with it saw a meteoric rise in the number of people moving home. The chart below shows a very clear spike in the total value of housing market transactions, which translated to positive sales growth in household goods sales (which includes furniture, lighting, electrical household appliances, hardware, paint, glass, music and video recordings and equipment).
However, parallel to housing transactions was the uptick we saw in home improvements. Soon after the onset of the pandemic, even those consumers that didn’t move house began spending more enthusiastically in the bulky goods/DIY sectors. This was driven largely by pent-up demand in the two years following the onset of Covid-19, in a period of heightened consumer savings. With the public spending increasing amounts of time at home, with many indeed working from home for large periods, consumers chose to invest in and improve upon their surroundings, particularly those that had saved money they would have typically spent on holidays or other large purchases in that time.
As a result, we also saw a renovation boom. A record number of planning applications were also approved for extensions and home improvements; in the 12 months to the end of last September 2021, 247,500 consents were granted in England, according to official planning statistics, 36% above the number signed-off in the year before, and a fifth above the pre-pandemic average.
Many furniture operators lost sales in lockdown but have seen strong recovery since their stores have reopened. Whilst it is possible to buy a sofa online, many consumers simply want to experience the look and feel of such an item before a large purchase is made. It is why showroom retailing in this manner is an important factor in out-of-town retailing and why the sector remains more defensive to e-commerce than other parts of retail.
Nevertheless, the recent rise in the cost of living will undoubtedly see many consumers cutting back, and it would make sense that this will include big-ticket items such as furniture and carpets that are less essential to our everyday living. The performance of the bulky goods operators going forward must therefore be monitored with some trepidation.
However, the chart above shows that despite a small reduction in the value of housing market transactions since the end of the stamp duty holiday, levels are still significantly higher than before the boom started. In reality, the uptick in housing transactions was as a result of more than just a stamp duty holiday. Pent-up demand and a change in attitude as people increasingly spend time at home have resulted in a desire for more and improved living space, and that, as yet, hasn’t gone away. This has kept demand high and, in turn, household goods sales also remain elevated – way above the levels we saw pre-pandemic.
It is important, therefore, not to necessarily tar all operators in the retail warehouse market with the same brush as we enter a period of rising inflation. Some may well see sales fall, particularly those that sell big-ticket items, but many will continue to see their fortunes remain elevated for some time yet. The recent trading statements of Kingfisher and Wickes suggest they are confident that people will carry on spending on their homes in the short term at least. Both DIY specialists have seen their UK and Ireland sales retract in Q1, but this is somewhat masked by such high lockdown-driven comparatives in their previous year’s performance. Kingfisher has remained well ahead of pre-pandemic trade levels, with the UK and Ireland‘s three-year like-for-like sales growth up 16.7% against Q1 FY2019/20. Wickes has posted a similar set of results; group sales remain well ahead of pre-pandemic levels, up 20.5% on Q1 2019/20, while core sales are 34.8% ahead of the same period.
Dunelm has also seen total sales growth of 68.6% in its latest performance figures, for the 13 weeks to the end of March 2022. Topps Tiles sees retail like-for-like revenues up 19.7% for the 26 weeks ending April 2022, and Pets at Home posting similar numbers, 15.8% retail like-for-like sales increase for the year ending March 2022.
As with any previous period when consumers have swung into belt-tightening mode, there are always winners and losers, and thus, the performance of the DIY, furniture, homewares and home improvement operators will need to be monitored closely and in isolation in order to fully understand where consumers are most likely to make savings.
The eviction moratorium limited insolvency activity during the pandemic
The financial strength of the sector does, of course, give the retail warehouse market some confidence in terms of insolvency activity going forward. A lack of any significant insolvency activity in the market has helped keep voids low in recent years. 2021 has seen no major brands with a significant out-of-town focus pass through a CVA, administration or liquidation. This, of course, hasn’t been exclusive to retail warehousing. However, now that the eviction moratorium has passed, the retail market, as a whole, may well be at a potentially significant juncture. While many retailers who relied on the moratorium may have had significant time to recover revenue and trade profitably again, its end could prove to be a catalyst for increased retail vacancy for those unable to pick up trade over the next few months or so, made more difficult in a period of rising inflation. The Local Data Company is therefore forecasting that UK retail vacancy will rise to 16.5% by H1 2022, up 0.7 percentage points from the 15.8% reported in H1 2021. It is our view, however, that should we see a flurry of insolvency activity post Q1 2022, the out-of-town sector is much better placed to weather the storm.
The recent trading performance of the retail warehouse sector‘s most prominent brands, coupled with the continued appetite for further expansion, suggests even now the moratorium has ended, a flurry of insolvency activity in the retail warehouse sector is, at least in our view, unlikely. At the time of writing, the only major insolvency activity we have seen since the end of the moratorium in the retail warehouse sector is the administration of Sofa Workshop, which went into administration and ceased trading at the end of March 2022. Although any brand loss is a negative result, the impact on the market, as a whole, was very limited, with only 16 branch closures. That said, the retail warehouse sector must tread carefully. The loss of a retailer that sells sitting room furniture items is perhaps an early indication of the difficulties such big-ticket retailers may face, as consumers cut back in response to the rising cost of living. The company reportedly also struggled as a result of supply chain delays and increases in transport costs which may prove a stumbling block for more retailers going forward.
However, the administration of McColl’s, the convenience store and newsagent brand, is the only other major multiple operator to have run aground since the moratorium ended. Although Morrisons has put together a rescue deal that will pay off McColl’s £170m debts and take on its 1,160 shops and 16,000 staff, its first task will be to decide what to do with the underperforming stores and old-fashioned newsagents where it is increasingly harder to sell cigarettes and alcohol and therefore turn a profit. This will undoubtedly lead to a number of closures on the high street and may well be the first of a number of in-town operators that might struggle going forward.
ESG improvements still need to be met
Environmental, Social and Governance (ESG) targets are rapidly becoming an increasing consideration for both landlords and occupiers, not just in the out-of-town market, but across all commercial assets and indeed property in general.
We explored this subject in detail in our December issue of this Spotlight; however, it is worth reiterating the point that by 2023, all retail property must have an EPC grade of at least E, and that by 2030, the standards must increase even further to at least a grade B.
The good news for the retail warehouse sector is only 5% of retail park floorspace is ranked as F or G in terms of its EPC efficiency rating and therefore needs improvement before the year ends (see chart, below). That said, there is a strong correlation between the worst-performing assets and high retail vacancy rates, which begs the question, in some instances, whether bringing some units up to grade will actually be worth the investment.
Looking ahead, with over a third of retail park space ranked as A or B in terms of its energy efficiency, the out-of-town market is undoubtedly in a better position than shopping centres by comparison, which has only 6% of floorspace meeting the minimum requirement for 2030. In reality, that means 65% of retail park floorspace needs to shift to at least a B rating in the next eight years, which may seem like a lot; however, the vast majority is already at grade C. The problem is therefore far less daunting than it is for shopping centres, where 93% of space needs an upgrade before 2030 (see chart above).
What are the sorts of measures that both landlords and tenants can implement in order to meet the government‘s ESG targets? Savills Earth, specialists in energy and carbon strategies, suggest five key considerations for both landlord and tenant, in order to see the quickest and most impactful return upon their EPC ratings (see chart, below). For landlords, the two most obvious involve the installation of EV charging points and using roofs for renewable energy generation. For tenants, improvements generally revolve around implementing strategies to reduce their consumption and increase energy efficiency. That said, with an average of 85% of retailers' carbon footprints wrapped up in their supply chains, changes to their retail portfolios are for now much further down their ESG agendas, placing the weight of responsibility on the landlord for the foreseeable future.
Investment market
After a significant up-tick in investment volumes and a fall in prime yields in 2021, will the momentum continue as the market adapts to its settled position in 2022?
As we highlighted earlier, 2021 was a strong year for the retail warehouse investment market. This momentum has continued into this year, where we have seen £616m of transactions in Q1, in advance of the £549m that we saw in Q1 2021. To put it in the context of other asset classes, the 115% year-on-year increase in transactional volumes in 2021 is even greater than the 75% increase in industrial/logistics investment activity, which has seen unprecedented positive investor sentiment in recent years, with the growth of online retailing.
While the overall make-up of the buyer pool was fairly heavily biased towards opportunistic and private equity in the first half of 2021, it is also notable that as the year progressed, some more traditional retail park owners were active, with both Threadneedle and British Land in the top ten of the most active purchasers over the course of the year.
Retail warehousing saw a strong recovery in investor interest in 2021, with the realisation the sector was proving much more resilient in the face of its various challenges than was the case with the rest of retail.
The relative naivety of some investors in previous years in tarring all types of retail with the same brush was based on the assumption that retail was increasingly being fulfilled online, thus eroding the relevance of the physical store.
As a result, all of a sudden, retail warehouse assets looked well priced, versus other types of property investment opportunities. Particularly to those that had spotted the fundamentals of the market were solid and improving.
Couple this with the fact that debt became easier to obtain towards the end of 2021 (admittedly from a position of being unobtainable earlier in the year), the volume of transactions took a significant upswing, particularly in the latter half of the year. While the terms on offer are generally pretty cautious, at around 50% LTV, this change does point to 2022 having the potential to be a more liquid investment market than 2021.
Downward pressure on prime pricing continued during the second half of 2021, and Prime Restricted and Open A1 parks saw a full 150 bps downward shift in yields, falling broadly in line with their ten-year averages at 5.50% and 5.25%, respectively. While the differential between the two groups that existed prior to 2021 has closed over the course of last year, perhaps justifiable given caution around fashion retailing in particular at that time, the rising weight of money targeted at retail warehousing, in general, has already closed this gap further in 2022.
Prime logistics yields are currently at 3.25% by comparison, suggesting investing in retail warehousing gives you a third more for your pound
Sam Arrowsmith, Director, Commercial Research
Both Prime Restricted yields and Open A1 yields have fallen to 4.75% by the end of Q1 2022. Activity in the investment market is very clearly being driven by the fact the very best retail warehouse schemes at least, continue to look competitively priced against other asset classes.
In a market where both credit risk and occupier performance remain strong, and we suspect to see continued rental growth as the year plays out, retail warehouse pricing looks increasingly attractive. Prime logistics yields are currently at 3.25% by comparison, suggesting investing in retail warehousing gives you a third more for your pound. That said, the logistics market is currently seeing very low occupational risk with record low levels of vacancy, leasing levels and strong rental growth; retail warehousing does have a question mark over the continued strength of household goods sales in light of the rising cost of living.
With yields as low as they have been since May 2015, landlords should be reminded that the next 12 months is a great opportunity to sell any problematic assets they have had for some time. Although the fundamentals of the market are strong, the current headwinds could increase the occupational risk, at least in some sectors, so with the weight of money and yield compression the market has already shown, now would be the time to move.
Looking ahead to the remainder of 2022, while some commentators are suggesting that the surge in activity in the retail warehouse investment market will accelerate, we remain a little more cautious. There will be both push and pull factors in play, and these will mean the transactional volumes might not be significantly higher in 2022 than in 2021. Private equity buyers, unless their ethos is more Core+ than Value-add, are likely to be seduced to other higher-yielding parts of the retail market this year (there are clear signs that the strong performance of retail warehousing last year is turning opportunistic investors’ eyes towards shopping centres, for example). That said, their withdrawal will, to a degree, be compensated by a steady return of domestic and European institutional buyers in the market.
Institutional buyers will indeed be more focused on the prime end of the market, comforted by the strengthening rental growth prospects, which has already led to further downward pressure on prime yields in 2022. However, private equity buyers are likely to be taking a hard look at what the prospects for real capital value growth will be over the next five years, and this will be another factor that might reduce their activity in this sector this year.
Rising build costs and the cost of greening assets will have a higher than average impact on any technical obsolescence costs going forward, which may influence buyer appetite in the long term, particularly as we edge toward the EPC grade B requirement in 2030. That said, the same is true for all real estate. Comparably, retail warehousing as an asset class is not only further ahead than others in meeting that requirement, but it is also considered to be a much easier sector with which to implement the physical changes needed to be compliant. Large units with flat roofs provide plenty of opportunity for photovoltaics (PV) or ‘solar panel’ installation/upgrades, whereas large car parks offer electric vehicle (EV) charging provision opportunities much more easily. It is therefore little surprise that the average unit size of an EPC A-rated retail property is five times as large as G-rated properties, highlighting how well placed the retail warehouse sector already is to implement change going forward, something any savvy investor will be sure to keep their eye on as time progresses.