frontier advisors

Jennifer Johnstone-Kaiser, Principal Consultant at Frontier Advisors

Real Estate Profile – Frontier Advisors Part II: Retail

Re-inventing the Fortress

E-commerce has changed the retail property sector forever, but how will this play out for shopping malls in Australia is not quite clear yet. Frontier Advisors visited the US at the end of last year, to get an idea of where we might be heading.

Not so long ago, retail malls were regarded as fortress investments, their returns protected against inflation and competition, thanks to Australia’s shopping centre planning regulations.

“The retail sector in Australia had been the best performer over 25 years – returns were in high single digits through to low double digits,” says Jennifer Johnstone-Kaiser, Principal Consultant with leading asset consultants, Frontier Advisors.

“Shopping centres had strong income flows to support returns. The sector was very defensive in that sense.”

Then, the tables turned. Mid-way through the last decade technology disruptions – online shopping and other innovations – began to upend the until then firmly-held conviction that Australian shopping centres offered the safest form of all property investment.

For the first time since the global financial crisis more than a decade ago, Australia’s wholesale retail funds saw negative returns for the year to January 31, 2020.

According to the MSCI/Mercer Australian Wholesale Monthly Property Fund Index, the return for retail funds, which have a combined asset value of $32 billion, was minus 1.7 per cent annualised, compared to 6.8 per cent annualised over five years.

Today, there is a new threat – the novel coronavirus, Covid-19.

Johnstone-Kaiser told [i3] Insights: “We are going to see accelerated stress before the extent of the coronavirus impact is known.”

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Retail will stabilise in time. The sector has a history of re-inventing itself, from traveling salesman to horse and carriage to the motor car to shopping malls and now omni-channel

As an adviser to superannuation funds and institutional investors with a combined investment of AS$30 billion in real estate, it falls upon Frontier to come up with solutions.

Its first word of advice is: “Retail will stabilise in time. The sector has a history of re-inventing itself, from traveling salesman to horse and carriage to the motor car to shopping malls and now omni-channel.”

Globally, retail continues to respond to structural changes, influenced by technology change, consumer preference and convenience of e-commerce.

She notes that UK online retail penetration is the highest amongst OECD economies, and the UK physical store experienced the earliest declines – a forewarning to other geographies.

The UK has gone further with its retail adjustment because of its Company Voluntary Agreement (CVA), which is similar to Chapter 11 in the US.

CVA gives tenants under financial stress the opportunity to declare bankruptcy and force the hands of landlords to reduce rents. Tenants thus become price-setters, and this has led to a natural attrition of shopping malls.

The US has experienced unparalleled re-adjustment as the shake-out of poor performing brands, centres and business models continues.

The US – more highly serviced in shopping centres than Australia – has gone through a wrenching experience with an ever-lengthening list of retailers going to the wall.

In November 2019, a Frontier team visited a number of US retail centres to ‘deep dive’ into structural changes.

The team found ‘light at the end of the tunnel’ but said higher capital expenditure would be required.

Johnstone-Kaiser says some US centres have been successfully repositioned and found a new lease of life.

“We visited a two-storey shopping centre in Nashville which converted its top floor into a thriving medical centre. It was in close proximity to Vanderbilt University, with a floor plan just right for medical office use.

“Patients waiting to see their consultants while away their waiting time shopping or having a coffee.”

The team also visited two former Sears department stores in Santa Monica and Oakland, both in California. They had been converted into offices, one with stunning ocean views and the other a funky office building that attracts tech workers and artists.

In another successful repositioning, Johnstone-Kaiser’s former local shopping mall, the Westfield Pavilion in West Los Angeles that once housed a Nordstrom department store, is to become a Google creative office and interactive mecca in 2022.

“This is truly a metamorphosis,” she says. “But repositioning is quite expensive.” The metamorphosis can take up to five years to achieve.

Johnstone-Kaiser says technological disruptions hit Australian shopping centre owners later than their peers in the UK and the US.

“There are some cultural differences between Australia and the US and the UK, so Australian retail may not be re-priced to the extent it has occurred in the US or UK,” she says.

For a variety of reasons, the take-up of online retailing has not been as rapid in Australia. One reason, notes Johnstone-Kaiser, is that Australia has one of the highest frequencies of visits to shopping malls in Asia-Pacific.

“Although e-commerce penetration in Australia is relatively low, it is tracking global trends. Retailers are seeing shifts in consumer behaviour and compressing retailer margins point to similar re-adjustment in Australia,” she says, adding that the coronavirus push to increased online shopping could have a lasting impact.

“It is hard to predict when retail will actually stabilise. During this period of adjustment, as the sector evolves to meet the changing preferences of consumers, capital expenditure (capex) will be required for defensive spend.”

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Retail is going to be under stress for the next three to five years before it stabilises

Frontier’s advice is to remain invested in retail, but to gradually reduce the weighting by allocating incremental dollars to logistics and niche sectors.

“Retail is going to be under stress for the next three to five years before it stabilises,” she reiterates.

“As new solutions and retail business models become profitable, your income increases and capex decreases – leading to value enhancement.”

The lesson from the transformation of some US centres, she says, is that owners/operators need to clearly understand and identify a purpose for their assets. Large centres, which have surplus land are looking to bring new uses to their sites – adding residential apartments, educational facilities or medical centres.

“It is less complex for these managers, but a simpler exercise is not necessarily less costly,” warns Johnstone-Kaiser. It can be quite disruptive to change a building envelope. It will take time and it can be very expensive.

“It requires downtime – you have to let go of tenants strategically to be able to expand and build new precincts.

“Valuing a mixed-use asset could be challenging. If retail is still the highest and best use of land, and if you are changing that use, the value per square metre could arguably be less. So, it is hard to know how values will be impacted in this mixed-use scenario.

“Australian centre managers are just at the start of this journey, and we don’t have any visibility as to the impact on valuations, yet.”

For now, the pressing issue for centre managers is looking at how they can adapt their centres to the new era.

Johnstone-Kaiser says that, just because the sector is going through a structural change does not mean it will be destroyed.

“The value of that investment is going to be impaired in the short term. (But) we still believe retail will continue to play a role in client portfolios over the longer term.

“As long as the retail sector can deliver consistent and sustainable yields well above bond yields, it will still be a legitimate and attractive allocation in investors’ portfolios in years to come,” she says.

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.