Thursday, 20 August 2020

COVID-19 has disrupted the Australian retail sector and forced a re-evaluation of the tenant-landlord relationship. In the second of our retail series, ‘What’s In Store’, KordaMentha explores how the shifting economic sands are likely to impact the retail property landscape, focusing on how revised lease structures and value-sharing initiatives might keep shopping centres sustainable.

Never has the interdependence of the retailer and landlord been clearer than during the COVID-19 pandemic induced recession. As we discussed in Back to basics: How retailers need to evolve to survive, the timing of COVID-19 pandemic has indeed amplified the importance of an omnichannel retail strategy. Physical space is no longer the only sales channel available to the retailer, nor is it necessarily a prerequisite. With stringent lockdown measures now in place in Victoria, consumers will have no choice but to purchase many products online, catapulting consumer behavior trends towards digital channels.
Australia Post’s 2020 eCommerce Industry Report reveals how prevalent the growth of eCommerce shopping and fulfillment has become, even prior to more significant isolation measures being introduced. Having predicted online shopping would account for 16–18% of total retail spend by 2025, Australia Post has since suggested pandemic driven growth has brought this substantially forward and that online spend may hold a 15% share by the end of December 2020.
The data shows an increase of 31% in April to 5.2 million people shopping online, when compared to the average in 2019. Online purchases are also growing at a rapid rate across the country; up a huge 41% year-on-year to April 2020, more than double the 17.2% rise in 2019. Perhaps not surprising with smartphones now giving shoppers access to more than three million stores now in the palm of their hand.
Technological advancements have occurred alongside a general slowing of total retail sales growth and downward pressure on gross margins. When these conditions are viewed through the prism of simple supply and demand principles, we can see fertile ground for a correction in the supply and demand dynamics for physical retail space. Will retailers still be prepared to pay the asking rents, with fixed terms and fixed increases particularly as the traditional bricks and mortar business model is being so significant challenged in the COVID-19 environment?
Worthy of consideration too is the influence of the IFRS 16 financial reporting standard that commenced in 2019. The requirement for lease liabilities to be recognised on balance sheet does not extend to variable payments, such as turnover-linked rent. While primarily an accounting adjustment that has no economic effect, avoiding the ‘optics’ of an increased liability position may further encourage retailers to pursue variable rent terms.
It is important to note that rental is not the only component in the physical space value equation. Tenure is becoming more relevant as fixed costs posed by rigid lease structures limit retailers’ ability to absorb changes to increasingly dynamic trading conditions.
High fixed costs amid declining revenues can threaten some retailers’ profitability or worse, solvency. Ultimately, what begins as a retailer problem becomes a landlord problem if the tenant cannot afford to pay the rent.
Conversely, retailers in stronger financial positions may be using this period of disruption to extend their tenure on more favourable terms with landlords where available.

Retailers and Landlord interdependence

 Landlords’ reliance on retailers’ capacity to succeed in a deeper, more competitive and effectively global market compels formation of a partnership based on strategic collaboration. This will require innovation, capital and importantly, compromise.
UK based Legal & General (LGIM Real Assets) has recently announced the launch of a new commercial leasing framework for retail and leisure occupiers. Described as a ‘flexible partnerships model’, it focuses on turnover rent options, marking a departure from traditional and rigid long-term leases, to a fully flexible approach that brings optionality to occupiers from start-ups all the way to superstores.
While this model is not yet prevalent in Australia, Australian retailers are recognising the opportunity it offers. One example may be ASX-listed retailer Premier Investments, which has reportedly renegotiated to pay rent as a proportion of sales across its 130 UK based stores.
This precedent highlights how the lease is a practical instrument through which to manage and foster mutual interest at this pivotal point in retail’s evolution. Beyond immediate commercial terms, the leases can guide a landlord-retailer partnership by binding each party to shared initiatives that transcend commercial terms for desirable mutual benefits.
Embedded lease terms to support co-sponsored innovation, for example better enabling technology-led and efficient click and collect fulfillment practices will deliver better consumer experiences and increase sales densities and productivity of retail stores.
A greater focus on stipulating carefully formed marketing initiatives or events that seek to generate fanfare, a stronger reputation and deeper resonance of the shopping centre within its existing, let alone potential, catchment is another area ripe for improvement.
Nonetheless, keeping shopping centres functionally relevant and sufficiently differentiated from the online experience will be contingent on the landlord’s capacity to curate a shopping destination, defined by exceptional consumer experience and sense of occasion that only a physical retail presence can achieve.
Another mechanism may be to recognise the contribution the physical store makes to online sales either directly (through sales fulfilled from store or click and collect) or indirectly where the store has been used as a showroom, but the actual sale takes place on-line.
While potentially hard to swallow for many larger retailers investing heavily in their digital infrastructure, it may be appropriate for smaller players, particularly if the digital infrastructure is being supplied by the landlord. This would create better alignment of interest in the new world of retail to enable scalable white labelled solutions to retailers where landlords could generate additional services revenue and data while removing traditional retailer costs and/or generating additional sales revenues.
As productivity from bricks and mortar stores has slowed, retailers have become more vocal about the need for more sustainable rents or, better yet, rent based on turnover only to provide ultimate downside coverage in turbulent times. However, the more recent asset valuation evidence and investor return requirements indicate compromise will be required.
Equity investors have in the past pursued retail property assets for their core, stable income return profile, supported by stringent lease documentation. A move towards more turnover-only, fully variable rental arrangements presents more immediate exposure to retailer operational risk that may conflict with the investment mandates of key supporters, including cornerstone, institutional investors. A change in the perceived risk profile among key investors will likely place further downward pressure on valuations.
Perhaps a middle ground needs to be explored whereby landlords provide some downside coverage through more sustainable fixed rents in exchange for, among other options, tenure and variable turnover rent structures. Sharing a proportion of turnover above a particular threshold may be one way to recognise real estate’s role in the omnichannel environment and align interests where these landlord concessions are made.
Establishing leases on terms flexible enough to support sustainable retailer profitability would prevent a significant increase in retail property vacancies and reduce compliance or monitoring costs for unsustainable legacy leases that may otherwise have retailer counterparty risk attached. Granted, the collaborative market reset would still be painful in the short term, but potentially less painful than an adversarial approach as it would at least provide a platform for future sustainability and long-term capital growth.
The changing economic landscape and the required initiatives to facilitate a soft landing for retail property assets will bring landlord strategy and asset management approaches into sharp focus, understanding that different principles and skills are required. Those landlords who are well-capitalised, with clear and effective tenant partnership strategies will be best positioned to build brand equity and success in the new world of retail.
Nonetheless, the hybrid model that may plausibly bring a sizeable reset in long-term landlord-tenant relations could also disrupt the short-term circumstances of many retailers, landlords and capital providers. We will identify and explore these potential impacts across the industry, as well as possible remedies and opportunities, in forthcoming publications.

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