Prime retail offers best value
The retail sector continues to outperform with yields driven down to a near five-year low as the institutions step up their buying activity in the face of still strong competition from private buyers and, in some retail segments, increased foreign investor interest as well.
The strong prices being paid increasingly reflect either an appetite for low risk assets or interest in long-term growth driven by reversionary potential or an asset enhancement opportunity, particularly as investors recognise that near-term rental growth prospects may be dampened if the consumer sector slows.
In the UK, the retail sector has outperformed the All Property market over the last one, three, five and 10 year periods, with the retail warehouse sector outperforming the retail market in general over the same periods. Likewise, the Irish retail property market has significantly outperformed the All Property market over one, three, five and 10 year periods.
Performance in the UK retail market has been good across all sub-sectors in recent years, with out-performance of the general market ranging from 0.9% pa for shops to 4.7% pa for retail warehousing over the past three years. With income returns similar across the sub-sectors, (in a narrow range between 6.4% and 6.6%), and in all cases lower than that seen in the market generally, it has been greater capital performance which has driven the market. Whilst yield compression is a significant part of this, that is also evident in other sectors of the market and it is in fact better rental growth which has been the key success factor for the retail sector.
Performance in Ireland has been driven to a greater extent by capital gains, with income returns remaining fairly steady historically. Income returns in the high street sector are significantly lower at an average of 4.3% in the last three years compared to 5.2% for All Retail. In the UK All Retail yields have averaged 6.5%. Across the retail sector, as in the UK, rental growth is the most significant driver for performance although in Ireland, retail gains from yield compression are much more significant than in other sectors – yields have in fact moved out over the past three year period in some cases.
Strong investor demand has tightened yields, making capital growth in both the UK and Ireland pick up. Such strong performance may be at risk in the absence of sustained rental growth, especially in the UK where there are expectations of a slowdown in the consumer sector.
The UK consumer has shown greater resilience than expected since the outset of the year, but recent data hints that sales performance may have peaked. In Ireland meanwhile, growth forecasts point to a further acceleration in spending in 2005 - helped by the deferral of interest rate rises in the Euro-zone. Nonetheless, rental growth is expected to slow after its strong recent run.
The prime headline shop yield reached 4.5% in June as buyers drove demand forward. With institutions determined to place their increased allocations, they are often now out-bidding private investors. Larger private buyers with significant equity backing remain a potent force, but the outward movement in swap rates has made many debt-backed investors less competitive. Yields, for the main part, are likely to be sustainable for the short-term and may fall further for prime stock before investor demand can be sated. However with strong prices being paid on secondary units, these yields may look more vulnerable next year.
There remains considerable appetite for shopping centre investments and the gap between prime and secondary has closed significantly. The prime headline yield for the sector is now 5.25% and yields are expected to remain stable over the next quarter, given an improving balance between demand and supply as more willing vendors come forward. The market has been dominated by a few large portfolio deals and has been particularly favoured by institutions as a means to place their increased allocations.
A number of centres have been marketed that were only purchased 18-24 months ago on yields, that at the time, were thought to be strongly priced. Yet these are now being successfully sold at higher prices. The outlook for the sector remains good but again, whilst yields appear sustainable at the prime end of the market, secondary yields may be vulnerable to potential rises when investor demand slows.
The retail warehouse sector continues to outperform in terms of rental growth – although, according to the IPD Monthly Index, shopping centres are outperforming in terms of total return. The polarisation between open consent and bulky goods parks remains, with fashion retailers more willing to pay the higher rents asked on the open consent schemes. Prime rental growth in the year to end June was 6.4% for open consent and 2.6% for bulky good schemes.
In the investment market, there remains an excess of demand relative to supply. More demand is, however, being satisfied as vendors start to take advantage of current pricing. The prime headline yield for an open consent park is currently 5%. Investors remain willing to pay strong prices where there is reversionary potential or angles to drive rents forward. As in other sectors, the yield margin between prime and secondary is expected to become more distinct over the coming 12 months.
Overall, the outlook for retail property remains positive in the UK and Ireland. Although there may be threats to secondary property and a gradual slowdown in performance over the next two years as rental growth eases and yields stabilise, the retail sector is expected to marginally out-perform the overall market in 2005, albeit with a narrowing performance gap as the office sector recovery gains pace. Over the medium term meanwhile, retail is expected to remain the better performing sector, particularly when considered on a risk-adjusted basis.
William Macleod is a partner and head of Healey & Baker Investment Managers