The changing face of retail

Of all the property classes, retail is much more like running a business than collecting rents. The property itself is the capital stock that allows you to operate the business. Retail properties form into locational oligopolies, dividing up catchment areas so that it’s not possible to locate another centre between them without affecting the financial feasibility of all. And the nature of the retail offering has been changing dramatically.

Over the last 40 years we’ve seen the development of a network of regional and subregional centres around Australia. Those networks are now mature, with little opportunity for new centres except in areas of population growth and with investment focused on expansion and refurbishment of existing centres. And we’re in the process of developing networks of bulky goods and convenience centres. Managing retail property is highly specialised and labour intensive.

Not many property operations are set up to do it well. But those that do, do it very well. It’s all about creating the most attractive place for shoppers and attracting shoppers to your centre. So, even with limited opportunity for new entrants, competition between centres is fierce, requiring frequent investment in competitive refurbishment to attract retail spending.

Times have been good recently. But it hasn’t always been so. And it’s about to change yet again. The 1980s were kind to retail property. The 1990s were tougher. The recession heralded a decade of low margins and low growth in sales for retailers, limiting the affordability of rents. Retailing was a difficult business. Retail centres saw a high turnover of tenancies and high vacancies – even in good centres – keeping rents flat and centre income static.

Even so, falling interest rates leading to firming yields augmented retail incomes to provide excellent returns to retail property investment. That has all changed this decade. Retail sales have grown much more strongly on average, sometimes booming, and much higher retail margins have made retailing a more attractive and less risky business.

How did this happen? Having languished below 2 per cent for much of the 1990s, real retail sales growth picked up to between 3 and 4 per cent early this decade before taking off into a debtfuelled spending binge in 2003 and 2004 when retail sales growth peaked above 8 per cent in real terms. Why? Because banks finally realised that Australians rarely default on their mortgages and, desperately seeking growth, bundled consumer credit with housing loans, effectively creating a line of credit for people with mortgages. “We’ll all be rooned!” cried the doomsayers. “We’ve borrowed too much.”

The subsequent fall in growth of retail sales was precautionary with households reducing expenditure to levels at which they were paying off debt. But they still had good jobs, household incomes were strong and that underwrote the subsequent resurgence in spending. Meanwhile, the rise in the Australian dollar has boosted margins. When the dollar rises, importers and retailers do not immediately pass on cost reductions as price reductions, but take the reduced costs as an increase in margins. It takes time for competition between retailers to erode those margins.

Through most of the 1990s, retail margins fluctuated around 2.5 per cent, but in recent years they’ve been above 3.5 per cent and in the last few quarters above 4 per cent. Strong growth and higher margins this decade have made retailing a much more profitable and stable business. The result has been a queue of retailers waiting to get into good centres while increased profitability has underwritten increases in rents and centre incomes. And firming yields boosted retail property returns.

For retail property, it was as good as it gets. And then came the financial shocks associated with the subprime loans crisis. Starting in the US, the credit squeeze, the economic setback and the fall in the sharemarket has played havoc with Australian listed property trusts (LPTs) – they call them real estate investment trusts (REITs) now. While the economy has stayed strong – Australia’s problem is inflation, not growth – and the credit squeeze has been mild compared with overseas, the setback to LPT prices and pressure on gearing means that a lot of property, including retail, is on the market.

We expect that prime yields will soften by half to 1 per cent, more for secondary, with a corresponding setback to prices and returns. And that brings us to the present setback to retail sales, as the Reserve Bank has been aggressively raising interest rates to curtail spending in an attempt to reduce inflation. The latest rise in the dollar has added significantly to margins – offsetting the moderating impact of the rise in the dollar on inflation – despite the weakening in retail sales.

Given the continued strength of investment underpinning the economy, demand inflation will not be easy to reduce. With strong household income and July’s tax cuts likely to once again boost spending, the RBA’s war against inflation is likely to be a long war of attrition. We think that interest rates have further to rise before this is over. We are forecasting lower growth in retail sales over the next few years as the impact of rising interest rates bites. But the strength of employment and household income should limit any weakness. Retail sales will still grow, just not as strongly.

After this year’s setback to retail property, due to the financial shock, we expect a rebound next year. But gone are the heady days of firming yields driving capital growth and the more recent ability to raise incomes. Cash flow will be solid rather than spectacular. But, compared with other more volatile property types, it will be steady. Five years from now many, but not all, of the nonresidential property market upswings will have run their course.

While other property sectors fluctuate with the ups and downs of the cycle, retail returns will be underpinned by its stable cash flow. This is the part of the cycle where retail property comes into its own as a solid underpinning of property investment portfolios.