FSP Retail Blog

Sustainable Rents in a Time of Change

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Retailers have begun to treat landlords as any other supplier, by telling them how much they are prepared to pay for their product. Proponents of this approach have already included Stylo, Aurora and House of Fraser. Although the catalyst may be the current economic situation, the change is likely to endure and the pioneers will be joined by others.

To use this approach successfully requires a thorough understanding of the suppliers’ business model. Similarly, to respond constructively, landlords and their agents need to know how much the retailers can really afford to pay, based on a good grasp of the relationship of their sales, costs and required investment. The basic purpose of any business is relatively simple – to create a product or service that can be sold for more than it costs to produce. In other words, the aim is to earn a positive return from the investment of time and money.

Evidence shows that for very long term sustainability, retailers need to earn a minimum average return of 25% on their investment in trading assets, their stock and fixtures and fittings. Retailers which have consistently produced lower returns have not survived long term. Therefore, in calculating sustainable rents FSP assumes a minimum required ROTA (Return on Trading Assets) of 25% and incorporates this measure into its Retailer Risk Assessment.

The current challenge for asset managers is to know which retailers to support. The Hot 100 makes a good starting point.

However, over the short term, cash-flow is king. As long as sales generate more cash than is needed to pay suppliers, the business can survive. However, with nothing set aside for depreciation or to pay the investors, this situation can be sustained only temporarily.

Thus the determination of whether, at a given level of turnover, a rent is sustainable depends on the time horizon. In current conditions, the time horizon may be short but understanding the impact of rent on the sustainability of the retailer is critically important. If you need a handle on retailer performance and sustainable rents, you know who to call…

Sustainable Rents in a Time of Change

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Retailers have begun to treat landlords as any other supplier, by telling them how much they are prepared to pay for their product. Proponents of this approach have already included Stylo, Aurora and House of Fraser. Although the catalyst may be the current economic situation, the change is likely to endure and the pioneers will be joined by others.

To use this approach successfully requires a thorough understanding of the suppliers’ business model. Similarly, to respond constructively, landlords and their agents need to know how much the retailers can really afford to pay, based on a good grasp of the relationship of their sales, costs and required investment. The basic purpose of any business is relatively simple – to create a product or service that can be sold for more than it costs to produce. In other words, the aim is to earn a positive return from the investment of time and money.

Evidence shows that for very long term sustainability, retailers need to earn a minimum average return of 25% on their investment in trading assets, their stock and fixtures and fittings. Retailers which have consistently produced lower returns have not survived long term. Therefore, in calculating sustainable rents FSP assumes a minimum required ROTA (Return on Trading Assets) of 25% and incorporates this measure into its Retailer Risk Assessment.

The current challenge for asset managers is to know which retailers to support. The Hot 100 makes a good starting point.

However, over the short term, cash-flow is king. As long as sales generate more cash than is needed to pay suppliers, the business can survive. However, with nothing set aside for depreciation or to pay the investors, this situation can be sustained only temporarily.

Thus the determination of whether, at a given level of turnover, a rent is sustainable depends on the time horizon. In current conditions, the time horizon may be short but understanding the impact of rent on the sustainability of the retailer is critically important. If you need a handle on retailer performance and sustainable rents, you know who to call…

Retail rental risk management

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Assessing the reliability of retail rental income, always important for asset managers and property investors, is now critical.  FSP has developed a Rental Risk Index (RRI) that quantifies the quality of rental income and is using its RRI to reduce rental risk particularly in shopping centres.  The premium attached to rents in a shopping centre lies in the centre’s ability to control its environment and tenant adjacencies, unlike the situation in most high streets.  The current pressure to take on any retailer without regard for tenant fit, simply to maintain the immediate income stream, will erode this premium.  It is not true that any retailer who will pay the rent is good enough.

Within the context of plunging retail property values, rental income is naturally the metric of choice.  With RICS and others predicting that capital values will drop a further 25% or more over the next two years, on top of a similar drop since 2007, income and its quality will remain the key consideration for a while.

Covenant strength alone is a crude measure of rental risk, totally inadequate for the current dynamic environment when some of the best retailers are relatively new and rapidly growing. 

Retailers are burdened by:
• pressure on Gross Margin from widespread and indiscriminate discounting
• falling value of the pound leading to increased merchandise costs
• consumers postponing big purchases as they struggle with debt and the threat of unemployment
• the absence of debt facilities for those needing to roll over loans

It is widely expected that in January there will be a spate of national retailers joining Woolworth and MFI in the hands of administrators.  In this context, FSP has developed a 5-point Rental Risk Index (RRI) to identify the degree of rental risk for any retailer.  The index takes account of some items that can be found in retailer accounts, such as Return on Trading Assets and the rent burden, but also includes an FSP view of the competence of the retailer.  Since shoppers determine the success of any retailer, it is extraordinary that their satisfaction is not normally a key constituent of retailer rental risk assessment.

If all this sounds heavy going, the FSP Team is happy to explain the Rental Risk management service in more detail.  Alternatively, take comfort from the fact that next week is Christmas and an opportunity to take a different perspective on what is really important.

Necessity is the mother of invention

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Will the historic distrust between landlord and tenant be permanently affected by the current economic crisis?  The antipathy has survived previous downturns, so why should this one be any different?
 
With national retailers going broke at the rate of one a week, and over 300 identified as on a “critical watch” list, retailers have a clear incentive to want to change the rules of the game.  The retailer pressure to move from quarterly to monthly rental payments is an archetypical “phoney war” - a token of a much deeper dis-ease.
 
However, the inertia of the system will prevent change unless landlords also see advantage in a new arrangement.  With the yield compression that made so many fortunes in reverse, the emphasis in asset management is to preserve and if possible enhance rental income.  Vacant units now represent a double whammy – not only no rent but a real cost through the imposition of full rates.
 
Unfortunately, there are commonly used approaches and behaviours that actually drive empty shops.  A couple of examples are:
 

• Setting rents on the basis of comparable Zone A - very effective for maximising rent per square foot but dysfunctional for filling shops.  If the desired outcome is fully occupied space, rents must give regard to the retailer’s ability to pay

•  Filling vacant units with any retailer willing to pay the rent, without concern for the appropriateness of the adjacencies thus created.  On the high street, this is undesirable but shoppers tolerate it.  Within a shopping centre, it degrades the environment, leads to shopper dissatisfaction, lower footfall and thus to further empty shops.  In anything other than the short term, this is a path to decline

 
The alternative approaches require different skills and knowledge.  So, will the rules of engagement between landlords and tenants change this time?  I think there is a good chance.  I believe history shows that necessity really is the mother of invention. The downturn in the early 90’s resulted in an increase, admittedly from a very low base, of turnover rents.  More importantly, town centre retailing as a whole is already under fierce competitive threat.  However much landlords and retailers distrust one another, they are mutually dependent. In the face of a severe external threat, perhaps they will bury the hatchet, even if they keep a note of where it is buried.

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