Is the Dire UK Retail Environment a Bellwether for the Rest of Europe?

The fate of physical retail? We all have our opinions though there is one question that seems to be prominent right now - will the devastating crash in the UK’s retail property market wash across to the rest of the Europe in the same way?

It’s fair to say that it isn’t a picnic in the retail property investment market anywhere else, but the UK and the US seem to have been hit with a heavier blow than most others. From a European context then, it’s worth focussing on the specific attributes of the UK’s market and which of these are the greatest contributors to this impact.

Sierra Balmain is a market leader in the retail property market and we find the regular conversations with investors and lenders that begin with the caveat “retail is not on the agenda” to be hugely frustrating. There is a simplicity with such a blanket position because the matter is more complex than face value suggests and the view is often formed through the narrow lens of the negative experience of both the US and the UK.

The central question to be addressed here is whether what has happened in the UK will inevitably happen elsewhere in comparable economies.

Let’s start with a blanket assumption of my own; the external pressure applied by online retail is spread relatively evenly across Western European (including the UK) economies where communications infrastructure is similar and that spread has happened and grown at pretty much evenly over a similar period. In other words, the impact of online retail is happening to everyone in the western world over the same time.

To further generalise, the same countries have similar wealth and spend characteristics to each other. To understand relativity of the impacts of online retail, the difference in existing physical space in the UK compared to these other countries is crucial to understand. 

If online trading hit western society at more or less the same time, then we need to understand the key differentiating elements and look at both a) the traditional guardians of the physical retail space (the investors, managers and the physical traders themselves), and b) the country’s specific geography, and physical infrastructure. It’s how these respond to the pressures exerted by online that will give different response outcomes.

The UK has long differed from the rest of Western Europe due to its institutional lease structure. This is the first reason why the UK has been hit deeper than those others.

For literally centuries, the concept of the institutional lease has been deeply ingrained in the UK property world. These leases concentrated on the following broad principles:

• Lease length was sacrosanct - when I arrived the UK in 1999 with Westfield, I recall the “scandal” in the industry as it was reported that the standard lease length was then below 20 (!) years for the first time. This was because institutional investors wanted long, steady income. Real estate was a bond and objects to be only to be maintained (at the occupier’s cost) not managed (in a modern sense of the word).
• Rent review mechanism – 5 years, upward only reviews. These are typically agreed between professional rent review surveyors (they do what they say on the tin) who usually operate independently to the management and retail functions they respectively represent. The outcome of the review is determined by comparative evidence.
• Comparative leasing – related to reviews above, rentals for retail space is “valued” based on a formula standardising the area of one store compared to its near neighbouring shops. In short, tenant A’s rent would be set based on evidence set by new lettings amongst its neighbours during the relevant 5-year period. If tenant A was, say, a butcher, and a jeweller was leased space next door to it for double the rent during the 5 years, tenant A’s rent would be expected to double on rent review regardless of its trading performance;  
• Leases are not granted unless the tenant had passed significant covenant tests. These were set to provide comfort to the landlord for years. Of course, this is desirable, but also has negative consequence;
• Rents are payable quarterly and in advance. A further cashflow burden on retailers that only the most established could meet; and
• Fully Repair and Insure (FRI) leases were standard – the tenants were obliged to hand back a building in the same condition that it took it on 20 years prior – roof and structure included. 

So far so good for the investor. The retailers who met and accepted the terms of engagement often benefited as well as they were usually offered space ahead of new entrants (how many established continental brands even failed to make a mark on the UK retail scene?). All well for the guardians of the traditional retail space also then. Even before the internet “asteroid” hit, this structure uniquely to the UK created the following major issues:

• Innovators and start-ups were effectively banned – choice and competition shrunk. Overall numbers of retailers (and thus choice for landlords and competition to drive innovation) were kept relatively low and existing retailers became comfortable dinosaurs.
• Business model flexibility for retailers and landlords was effectively discouraged – there was no incentive to modernise, adapt and change offer.
• Tenant mixing and place making was also effectively discouraged due to the comparative leasing structure. The opportunity to create contiguous, vibrant and themed highstreets and shopping centres was basically by-passed and disincentivised.
• Financial hurdles –When set too high, covenant tests, cash to meet quarter in advance rent, FRI obligations etc significantly disadvantage start-ups and innovators. The small group of existing, non-adaptive retailers again benefitted. Anyway, what retailer has a 20-year business plan?
• Investors and managers were ill-equipped to understand what was happening or to make rapid changes when the writing was becoming clear in the early 2000’s.
• Vital trading performance information is not shared. Retailer sales information is vital real time information that allows owners and managers to adapt tenant mix and marketing over shorter periods. Red lights are flagged early. 

This was the state of the land when the online challenge came. It is a state, which to a great degree still, is jealously defended.

Perhaps on reflection, the online “asteroid” metaphor is not so appropriate in this context.

Granted, over the hundreds of years of institutional lease statis, the last 20 years is in effect a blinding flash. But looking real time at the last 20 years, the evolution was slower and thus arguably could have been predicted. Where the rest of Europe +/- faced the same pressures from online over the same timeframe, the broad lack of the pre-existing conditions outlined above has already shown the impacts to be less dramatic and devastating. The UK was both unable and unwilling to make the structural changes needed to adapt, even over a 20 year with-hindsight view.

Now add to that, the UK legal system in which occupiers can use a law never intended for real estate, to break leases where they can no longer meet their obligations. As described above, the historic lessor and lessee relationship never created an overly collaborative environment and so when occupiers saw the opportunity to use CVA’s (Company Voluntary Arrangements) the opportunity to do so was compelling. There is little choice for the lessor and the lessees found an instant remedy to an age-old problem.

The UK government has sought to balance its books by raising business rates on real estate with no relief for vacant properties which, thanks to much of the foregoing, are significantly on the rise. The impact on both the investor and the occupier of this is hugely significant. The government has been widely condemned and remains frustratingly deaf on the matter. This quashed any chance of creating a competitive environment was dealt a further blow, whilst at the same time the global tech giants merrily trade “frictionlessly”.

The problem here is that CVA’s, real estate tax, and the lack of taxation on tech giants cannot be structured around in a way that, say, you can change a form of lease agreement. These matters can only be lobbied for change which, to date, had had no effect despite the constant and sustained efforts of heavy-hitters on both sides of the investor and retailer fence.

Leases structure reform is an opportunity to partially control the future in the sector. A vast number of managers, retailers, banks, valuers, legal advisers, and accountants do collectively have experience from the rest of the world and hence the ability to implement a “new” approach is actually possible and will be understood widely by most international parties. The implementation of a new lease arrangement, though, will need broad efforts from the institutional and agency market to shift, and not just by a small handful of innovators. However, the purpose of this note is not to get into the options of those as that is a proper wormhole itself!

The second key differentiating condition in the UK to other Western European is geography and physical infrastructures. Without diving in too much for this piece, the UK has a dense population that is exceptionally well connected by road, rail, air and of course telecoms – all over short distances. Whilst the retail property industry sat on its lease structures, the physical infrastructure of the country was being merrily built up creating a perfect ready-made environment for its yet unknown shop-killer to slide into.

As the UK also sought to take the lead in Europe on being an attractive place for technology to be based, the government incentivised rather than taxed the tech businesses who are happy to exploit the efficient infrastructure laid on. 

It is tempting to draw comparison in the UK to the form of shopping centres developed in the US, which could be correct up to a point. The department store-anchored model is more UK/US than continental, however the UK high street is more ingrained, and it has fewer super-regionals on major motorway junctions. The US was doomed by these factors but had a better lease structure. Unfortunately that lease structure was of no use for land anchored by 4 extinct dinosaur tenants on land that was only good for, well, logistics and Amazon sheds.

Although other Western European countries undoubtedly have their weak points (and certainly none of them are bathing in the glow of a retail property boom!) in my opinion the UK’s existing conditions explains – perhaps uniquely – why it has been hit so hard by the same pressure that other European countries experienced in parallel. Because of these, I don’t expect that this will now flow further into the Continental European space and I also expect that the undoing of the UK’s problems will need to be tackled in a very different way.       

In order to address the challenges of physical retail investment, the conversation needs to be rational, flexible and overall, pragmatic. It is vital to understand the true underlying drivers that affect both value and define opportunity and these will vary country to country and amongst sub-sectors in the industry.

There will undoubtedly be a necessary reduction in the amount of physical retail space all over. It bears stating the obvious that the contraction will not go from 100 to zero though. There is a balance that will both meet the supply / demand economics and deliver a new paradigm for retail, entertainment, leisure, lifestyle, culture, workspace, living and omnichannel.

This pricing vs valuation dilemma right now, will adjust to a longer-term stable valuation scenario. You just need the right focus, patience and wide-ranging cooperation to deliver it.

And, naturally, the right manager.