Rethinking the nature of retail shopping

FRANK GELBER
AUGUST 9, 2018
The Australian
Traditionally, good retail centres have been regarded as a low-risk, high-quality investment. A well-run centre with a secure catchment provided a reliable return. But retailing is changing dramatically. And shopping centres face a new set of challenges that will ­affect property and tenancy risk.
They will drive changes in the nature of the offering provided by retail formats. That process has just begun and there’s a lot more to come.
Running retail centres was always hard work, much harder than leasing offices or industrial premises. And there were always centres that fell by the wayside. Shopping centres are a locational monopoly locked into competition with their neighbours to secure their catchment and hence their share of retail spending.
And there is a continual process of rejigging centres to maximise spending. Accordingly, they were locked into competitive refurbishment and always had to work with tenants to be attractive, win retail traffic, spending and cash flow. In the end, a good centre was a licence to print money.
That’s all much harder now.
I’m not just talking about the rise of online shopping, which already has an 8 per cent share and is growing at 15 per cent per annum, taking some of the growth out of shopping centre incomes. The question is: what share will it end up with when the sector matures? The concern is that the entry of Amazon will further boost the online share. Retailers have been responding by developing their own online shopping facilities, with mixed success.
Probably more important is the change in consumer spending patterns. We all know about the continued weakening of department store sales. In many centres they are being subsidised to boost the attraction to shoppers. Even so, their footprint is shrinking.
Myer’s response to the weakness of sales and profits has been to close a number of underperforming stores, leaving a gap to be filled in those centres. And there are more closures to come.
That is being compounded by the more recent weakness of discount stores (apart from Kmart). For the centres that lose or see smaller department stores and discount department stores, the issue is what they will do with that space. Will they be able to replace those tenancies or will the reduced offering damage the viability and attractiveness of the offering to shoppers?
The other issue is the medium-term shift away from traditional retail sales to services expenditure. Apart from food, that is, where expenditure remains strong.
Already, we are seeing more medical centres, childcare and gyms along with an expansion of food courts. But this is just the beginning. There will be experiments with entertainment and leisure and even less traditional retail formats. It will change the nature of centres, and that will require active management.
As the different formats compete for these services, the question is whether there is enough of them to fill the gap left by the weakness of traditional retail sales. The other question is whether those centres that don’t increase their offering will still be attractive to shoppers.
All this comes at a time when weakness in the economy has meant household income and expenditure, and hence retail sales, are weak.
That has highlighted the problem for retail. It has been offset to some extent as households spend more of what they earn, keeping expenditure and retail sales growth stronger than household incomes would suggest. And centre incomes are to some extent sheltered from the weakness of retail sales by the better performance of the larger retailers and chains, which predominate in ­regional and subregional centres.
The good news is that we are probably at the bottom of the household income growth cycle now, but continued slow economic growth will impede the pick-up in employment and wages, which will drive stronger growth in income. Given the impending fall in residential building, we don’t expect growth to strengthen until the turn of the decade. Retail sales will pick up from here but will remain constrained until economic growth and wages pick up.
Despite the loss of spending to internet shopping and services, expenditure in shopping centres will continue to grow, but modestly. We certainly won’t see the heady growth of a decade ago — those times are long gone.
The upshot is that we expect centre incomes to increase by just under 3 per cent per annum over the next decade, with growth lower in the first five years than in the second.
But there is another problem for retail property on the investment side of the equation. Retail property has performed well since the financial crisis despite weak growth in centre incomes. The reason is that falling bond rates and firming yields have underpinned strong capital growth and returns for property investment.
The problem is that bond rates have bottomed and started to rise. While there has not yet been a discernible impact on retail property yields — in fact, buying pressure is holding yields firm — we expect rising bond rates to lead to a softening of yields over the next five years. Over that period, this will negate much of the growth in property values that would normally be associated with rising centre incomes. We expect centre values to remain relatively static.
But five years from now much of the impact on yields from rising bond rates will have washed out of the system. In the second five years of next decade, that negative influence will have run its course.
We expect an internal rate of return for regional centres of 5.5 per cent over the next five years, lower than institutional hurdle rates, but 6.5 per cent over the full decade. Subregional centres will do a little better because of their higher yield, but face greater tenancy and property risk. And successful large-format retail centres will do better still.
Longer term, retail property yields will depend more on the perceptions of risk associated with the impending structural change to retailing and retail property.
The real point is that substantial changes will be required to meet the challenges from changes in the share of internet shopping and expenditure patterns. It’s not all negative — but active management will be required.
The better-managed, better-performing centres should do relatively well.
The upshot is that we are rethinking the nature of retail shopping facilities. We need to view retail as less of a uniform class and to differentiate between investments on the basis of tenancy and individual property risk in an environment where the offering is facing major change. Not only will we see the addition of services within retail formats, but we are also seeing experiments with mixed uses such as hotels, residential and office facilities in shopping centres.
We still have to see how that works itself out between regional, subregional and large-format centres. I think that the best of them will look more like community centres than what we are used to as shopping centres. In any case, centres will look very different in 10 years time. And performance will depend on how they manage the change.
Frank Gelber is chief economist at BIS Oxford Economics.