Most property people think retail prop erty is relatively insulated from cycles because of its secure cash flows. While the current market is being affected by both the problems of the listed property trusts (LPTs) and the weaken ing of retail sales, the logic is that once this is all over, retail returns will recover and resume growth. While partly true, there has been a fundamental shift in the retail operating environment, which will continue to affect retail property returns for some time to come.

In the last big downturn post 1989, commer cial, industrial and tourism property collapsed. But retail property was relatively insulated. Secure cash flows underpinned returns and property values quickly recovered.

Indeed, throughout the 1990s retail property performed strongly. Mind you, retailing was a tough business with strong competition and reluctance to raise prices leading to tight margins. Retail busi nesses had a high failure rate and empty spaces in retail centres meant that there was an affordability limit on occupancy costs. Rents remained relatively constrained. Strong returns were underpinned by capital growth, more because of firming yields than rising incomes.

That changed this decade with, until recently, strong growth in retail sales and significantly higher margins underpinning growth in retailer profit ability. And that flowed on to returns for retail property owners.

The financial crisis brought that to an end. The gearing problems of the LPTs, led by Centro, mean that a lot of retail property is for sale with few potential purchasers. The sales market isn’t clearing. Yields have softened, but that’s just the beginning. The major impact on property values will be this year. And the extent of the damage will depend on the aggressiveness of financiers in securing reduc tions in gearing in an environment where falling prices are operating to increase gearing and reduce net asset backing.

Meanwhile, retail sales have stalled, initially because of the RBA’s tightening of interest rates until April 2008 and then, as the financial crisis hit, because of precautionary saving by households fearing loss of jobs. That has affected retailer profit ability and, in some cases, viability. The setback to retail sales is leading the weakening of the economy. Worst affected are items of discretionary expendi ture, with necessities faring relatively well.

The Federal Government’s fiscal stimulus pack age in December was successful in boosting retail sales, particularly for discretionary expenditures which had been languishing in the year to Novem ber. Sales for department stores, clothing and soft goods and household goods recovered strongly. Only restaurant expenditure remained weak. And there’s another fiscal stimulus package to come.

Meanwhile, despite a substantial boost to household disposable income in the mortgage belt as a result of the aggressive reduction in interest rates – now a full 4 percentage points – weak con sumer confidence means that households continue to save and repay debt. But that won’t be forever. Once confidence returns, expenditure will recover – the only question is when and by how much.

Will that mean the end of problems for retail property? I’m afraid not.

Something more fundamental has happened to change the outlook for retailers and prospects for retail property.

Strength of retailer profitability through much of this decade was not due solely to strong retail sales, though that helped. Rather, the primary driver of profitability was the significant rise in retail margins from an average of between 2.5 and 3 per cent through most of the 1990s, rising signifi cantly this decade and up to 4 per cent by the end of 2008. It was truly a golden age both for retailing and retail property.

But that’s over now. The rise in margins was underwritten by the rise in the Australian dollar from $US0.50 at the beginning of the decade to almost parity last year. At $US0.50, importers were squeezed. But as the dollar rises and costs fall, importers don’t pass on the full cost reductions. Rather they price to meet the domestic market, taking lower costs as a windfall gain boosting mar gins and profitability. And a large part of Australian retailing has significant imports, more so now than at the beginning of the decade.

But now the dollar has collapsed to around $US0.65. And competition works better in an increasing cost environment with importers reluc tant to raise prices. That’s particularly so in a weak demand environment such as now. Margins will be squeezed, falling from the current 4 per cent back towards the levels of the 1990s. Retailing will be a much tougher business with higher business fail ures and lower profitability. Certainly, some sectors will be relatively insulated, particularly those based on domestically produced goods and services. But imports and import-competing goods prices will rise significantly, affecting both margins and de mand as consumption switches towards domestic goods. And that will affect returns to retail centres.

Retail will survive the economic downturn and the financial crisis. It’s still a secure cashflow invest ment and will rebound after the current shock to yields. It remains a core part of a long-term property portfolio. But, as long as the dollar stays low, we won’t return to the boom conditions of earlier this decade. This is the end of what has been a golden age for retail property.

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