Retail real estate: a safe haven in uncertain times

Due to the Internet frenzy cooling off and the economic downturn since 2001, investors are looking for safe havens. With European countries increasingly dismantling state-funded pension systems and interest rates at record low levels, property has become a popular long-term investment. Retail real estate is in demand and hungry investors are keen to put up with increased risks.
Elsevier Food International Vol.8, No.4, November 2005
Bert Erik ten Cate

When in March 2005 a group of Irish private investors bought a couple of shops in the P.C. Hooftstraat, the most prestigious shopping street in Amsterdam, local investors shook their heads in disbelief. There was nothing wrong with the shops or the tenants. It was the net initial yield of 4.7 per cent.

Local investors thought this was too low for retail assets, even if they were top quality. They are used to 5.5 per cent or more but for the Irish investors it was better than the 3.5 per cent they would get for prime retail in Dublin.
The case is an illustration of the Europe-wide hunt for retail assets. Short supply and low interest rates have pushed up prices everywhere, resulting in ever-lower yields. Limited by the few opportunities in their own markets, investors from literally everywhere are looking to add retail assets to their portfolios. In their search for higher returns, investors do not shy away from buying whole businesses and enter new markets in central and eastern Europe and Turkey. The returns may be higher but so are the risks.
The quest for all sorts of property - office buildings, logistics warehouses and retail – has intensified since the dot.com bubble burst five years ago and stock markets took a tumble. The economic downturn was further exacerbated by the 11 September attacks. Property is not only a safe haven, it has even outperformed stocks and bonds.
At the same time, more and more European countries have begun dismantling state-funded pension systems. Property is a popular long-term investment as its value goes up with prices. Many property funds have sprung up to provide insurance companies or private individuals an indirect route into property.

Retail demand
In 2000, investors spent a total of €63.2billion on European property, according to figures produced by property consultant Jones Lang LaSalle. Retail accounted for 19 per cent or €12 billion. In 2004, total property investments had climbed to €102.2 billion. Retail investments represented 26 per cent, or €26.6billion.
As most investors have built up a substantial portfolio of office buildings, they are increasingly turning to retail assets. Retail is attractive, because it is relatively safe to invest in, especially when it involves top assets in prime locations.
Here, location is more important than the credit-worthiness of the tenant as there will always be another retailer waiting to take up the space in case the current tenant defaults. Therefore, high-street shops are popular with many investors, especially with local private investors as they know the area.
However, for property fund managers who are under pressure to spend large sums of money, high-street retail assets are not very attractive, because it involves a lot of work - both in terms of acquiring and maintaining the property. They prefer investing larger amounts of capital in mostly out-of-town located shopping malls. However, these are available in limited numbers due to government restrictions aimed at protecting the high streets.
For large property investors, shopping centres and retail parks are the only retail assets left to acquire. They fetch high prices thanks to a combination of high demand and restrictive planning policies. In general, however, owners of shopping centres are reluctant to sell. In case they do decide to sell, they will want to invest the proceeds in other property but they know they cannot because demand outstrips supply. In western Europe, there is little room for new shopping centre developments. In most countries, out-of-town developments are restricted as politicians fear that these will have a cannibalising effect on existing shops in city centres.

Sale and leaseback
Investors can also add retail assets to their portfolio through sale and leaseback transactions with retail operators. Investor interest is great for good quality retail assets, particularly in the UK. Here, limited availability, low interest rates and high levels of liquidity, especially in the debt market, have allowed companies to push boundaries in flexibility.
In March this year, Tesco signed a UK£366 million sale and leaseback agreement with a private company, Consensus, which bought 12 Tesco stores and two large warehouses in the UK. The deal provided the investor with a 5.2 per cent return.
Property investors find assets from food retailers particularly attractive. Even if the economy sags, people will still need to eat, so the reasoning goes. Most supermarket operators, however, still own the majority of their property for strategic purposes. They will only sell stores when they need cash for expansion or because they have too much property assets on their balance sheets.
“Operating in one of Europe's most competitive retail sectors, food retailers are looking at all manners of capital raising initiatives to fund expansion,” says Shelley Matthews, associate director of Jones Lang LaSalle's European Retail Capital Markets team in London. “Sale and leaseback is one such option - essentially a financial decision; what is best for the balance sheet? In part, it is also a question of whether the retailer is best in class at managing their properties."
When food retailers start putting whole portfolios on the market, investors can be sure that the supermarket operator is in trouble. Two years ago, Metro failed for the second time to offload a €3 billion property portfolio. The German retailer needed the cash and had bundled assets of mixed quality in the portfolio. But Metro's price expectations did not match those of investors who were left with many questions, including some regarding contaminated land. In the end, Metro called off the sale, saying it did not need the money that desperately as sales came in better than expected. Metro then quietly started to sell and leaseback the best assets from that €3 billion portfolio.
Now, the Swedish branch of Coop Norden needs cash. It has financial difficulties due to strong competition from rivals such as ICA. Coop Norden is willing to sell and leaseback the entire €1.3 billion Nordic property portfolio, including Norway and Denmark, if the sale of the Swedish portfolio goes well.
Investors will be paying more attention to Coop's financial health than to the quality of its real estate. Planning permission is relatively easy to obtain in Sweden as the country has enough land and local municipalities are all too willing to raise cash by selling off land. This increases the investor’s risk, might the tenant not be viable to sustain the duration of the lease contract.

Investors go east
Since investors have difficulty finding existing retail property in Europe's mature markets, they are increasingly seeking out new markets. Central and eastern Europe and Turkey, have become hot spots for investors. In Poland, Hungary and the Czech Republic, retail investments have overtaken office investments in terms of investment volumes. Against slightly rising vacancy rates, competition for long-let office building is strong. The retail sector is booming as the population is becoming more affluent.
Between January and mid July, a total of €1.58 billion of retail assets changed hands in Poland, Hungary and the Czech Republic, according to Jones Lang LaSalle. Demand has been so high that yields on retail properties are now similar to those in more mature markets, such as Germany and France, while the risks are considerably higher.
The biggest risk is the lack of zoning policy in these countries. An owner of a shopping centre may one day find that they are building a rival scheme next to his. Investors can give their shopping centres a competitive edge by buying a real estate project anchored by a food retailer. A food license is more difficult to obtain than planning permission in certain markets and a food retailer may generate extra footfall for other stores, such as fashion stores, in the scheme, according to Chris Warren, a partner at property consultant Cushman & Wakefield Healey & Baker.
However, more shopping centre space is coming to the markets of central and eastern Europe. This year and next year, Poland will get an additional 1.6 million m² of new shopping centre space; the Czech Republic will get 307,979 m² and Hungary 112,000 m². These countries are currently lagging the EU25 average of 159 m² of shopping centre space per 1,000 inhabitants. Countries such as Germany are also behind but that is because there is a stronger culture of high street shopping.

Pushing the boundaries
While it is natural to assume that countries in central and eastern Europe have some catching up to do, it remains to be seen how long consumers can keep on spending. The large multinationals, which brought prosperity to the region, are signing flexible leases on the office buildings. This way, they can move to cheaper countries, such as Bulgaria and Romania, as soon as the opportunity arises.
Food retailers such as Tesco, Ahold and Metro, entered the markets in the 1990s by developing real estate projects themselves. Wal-Mart is looking at the region, but market observers believe it will only be successful if the US retailer buys an existing operator; Tesco, Ahold and Metro have a first-mover advantage over Wal-Mart.
Inevitably, the development boom in central and eastern Europe will lead to winning and losing shopping centres. Georg von Hammerstein, director of acquisitions at Pramerica Real Estate Investors in Munich, points out that Warsaw has ten shopping centres whereas Munich only has three.
In their search for higher returns and new developments, some investors are turning to Turkey. Among the most recent investors are Dutch investor Corio and German fund manager CGI. Corio bought a 46.9 per cent stake in local fund Akmerkez, which owns the 180,000-m² Akmerkez shopping centre in Istanbul.
CGI bought the Bornova shopping centre in the city of Izmir for €80 million. Frank Pörschke, managing director of CGI, hailed Turkey as "among the world's most promising retail locations." He pointed out that the average retail space for every 1,000 people equals 20 m² compared to a European average of 200 m².
Turkey is not to everybody's taste, though. Some find that the returns do not properly reflect the economic and political risks. Corio only realised a net initial yield of six per cent. As in other European markets, prices will go up and yields will come down, not because the market fundamentals have changed but simply because there are so many investors chasing the same assets.
Joe Valente, director at DTZ research, put it quite bluntly when he told a property conference in Copenhagen earlier this year that "Turkey is somewhere you go for a holiday."
He said he was worried by the high prices being paid for European property as borrowing was cheap. Many investors are borrowing as much as 90 per cent of the purchase price. As long as there remains a gap between interest rates and returns, they will pay less attention to the underlying fundamentals of the markets in which they invest. ”People are buying property rather than investing in it," said Valente.

Sprechen Sie Deutsch?
This investor attitude rings particularly true in Germany. With yields at seven per cent or higher and the cost of borrowing at 3.5 per cent, Germany has turned into Europe's hottest place for international retail investors. It does not seem to matter that the Germans are not spending. The Germans are saving more than ten per cent of their disposable income as they are worried about their jobs and the country's economic prospects. Retail sales fell 1.7 per cent last year to €365 billion, according to Mercer Management Consulting.
"Foreigners still believe in a strong Germany; only the Germans don't believe in it," says Marc Werner, a partner at law firm Lovells in Frankfurt. "Foreign investors buy retail because the prices are reasonable and interest rates are low. You can buy long lease agreements signed by the top ten retail companies."
The majority of buyers are first-time buyers from the UK. CIT Europe, for example, paid €100 million for a German retail property portfolio from Hamburg-based developer Procom. The portfolio contains three supermarkets, three hypermarkets, two shopping centres and one "home textiles" store. The sale of two of the assets has been deferred pending the completion of construction.
UK Investors are attracted to Germany, simply because there is a lot to buy. They find it increasingly difficult to buy property in their own market and are often used to financing real estate with ten per cent own capital, whereas 90 per cent of capital is raised from the banks. In combination with a deal based on non-recourse debt where the bank takes the risk might business turn out to be disappointing, Germany seems worth a gamble. Even so, investors do not want too big a gamble. That is why they are mainly investing in retailers that supply basic goods, such as clothing and food. Discount stores, such as Aldi, Lidl and Plus, are the preferred tenants as they control 40 per cent of the market.
The big question, of course, is how investing in Germany will work out in the long term. Yields are expected to come down; prices are rising as more and more investors pile into the country. They will continue to come as long as there is a big enough difference between yields and interest rates. But it may take years before the economy rebounds and there is enough room for rental growth.