Falling profits, store vacancies set to hit retail property hard: BIS Shrapnel

Despite record retail property transactions in 2012 and continued keen interest from both institutional and private investors, the retail property sector is facing its greatest challenge since the post-GFC period, according to BIS Shrapnel.

Profits are expected to fall and store vacancies to rise as retailers and landlords struggle against numerous structural headwinds including modest retail turnover growth, the continued growth of online shopping, continued high savings rates coupled with the lack of an economic boom, a peak in new retail commencements in 2013–14 and a substantial depreciation in the Australian dollar.

Investors in strong shopping centres should expect solid, but not spectacular returns.

For those in less successful centres, returns will most likely weaken.

Yields may firm in the short term as investors continue to be attracted to the sector, but BIS Shrapnel says overseas investors are likely to be less aggressive when the Australian dollar is lower, especially if bond rates rise.

A key concern is the devaluing of the Australian dollar, which fell 8% over the course of the 2013 financial year.

“Based on our forecasts of a 23% depreciation against the Trade Weighted Index (the Australian dollar’s performance against the currencies of its biggest trading partners), we estimate that a retailer which imports 50% of product sold will see its profitability fall to zero if it is to continue to pay current rents,” says Maria Lee, senior project manager at BIS Shrapnel and author of a new report looking at retail property market prospects between now and 2023.

“Clearly, this is not sustainable. This will impact their ability to pay rent, and vacancies could also be expected to rise.”

Taking all factors into account, BIS Shrapnel forecasts shopping centre incomes to grow at an average pace of just 2% per annum over the next five years—failing to keep pace with CPI inflation.

As the chart below shows, operating profit as a percentage sales is expected to fall over the next four years from around 7% currently to less than 5%.

As a consequence retailers and shopping centre owners are going to have to work harder than ever to remain relevant and sustain growth.

“In our view, retail property faces its greatest challenges in decades—barring the immediate post-GFC period,” says Lee.

The report estimates that the market share of Internet retailing could likely increase from 6% at present to 11% within five years.

“What this means is that more than $3 out of every $10 of additional expenditure will go online,” says Lee.

“Put another way, the turnover growth through shopping centres would be a full one percentage point higher without the growth of online shopping. That’s highly significant.”

The impact of a growing online shopping channel is two-fold says Lee.

Firstly, it takes market share from “traditional” bricks-and-mortar retailing and secondly, through the use by shoppers of price comparison websites or apps on mobile phones, retailer profit margins are impacted as consumers demand a price-match in order for them to buy there and then.

“The weak prospects for income growth have clear implications for total returns to retail property,” says Lee.

“Pre-GFC, even if income growth was weak, total returns were nonetheless solid thanks to the long term firming of yields. But that process has run its course and we don’t expect to get back to 2007 yields before the next boom—which is unlikely to be in this decade.”

“Nonetheless, strong retail centres remain a good cashflow business with relatively little fluctuation in income returns. Retail property offers solid, if not spectacular, returns.”

This article first appeared on Property Observer.