Investment activity in the European retail sector, while down, is holding up well relative to the commercial property market as a whole. Lynn Strongin Dodds investigates retail's potential to ride the current storm

In past economic downturns, retail real estate has always proven its mettle as a defensive play. The question today is whether its attributes will be able to weather the severity of this particular financial storm. The general view is the sector should hold its own, but investors will have to become more discerning in terms of location, tenant covenant and asset category - shopping centres, high street outlets or warehousing.

"As with other sectors of the property market, there has been a dramatic drop in transactions," says Neil Turner, head of international property investment and research at Schroder Property Investment Management. "Institutions, though, have always favoured retail in an economic downturn, because it is often less volatile than other property sectors - for example, the office sector. Retail could be more affected during this financial crisis, but the fundamentals, such as demand and supply imbalances, in certain countries mean it should be less impacted. The important thing is to invest in the right type of retail property in the right location."

John Welham, head of European retail investment, CB Richard Ellis, adds: "Retail demand held up reasonably well in 2008 compared with other sectors, although it was impacted. One of the main reasons it is attractive is due to the nature of its tenants. Historically, the sector, especially prime retail, has performed better with better income consistency and lower vacancy rates than other property sectors during economic downturns.

"Retail is not as footloose as office, which tends to have fewer tenants per volume of investment. If a major office tenant decides to make cuts then the effect can quickly impact on the occupancy levels in the building. This is not the case, for example, with a shopping centre. The tenant mix is more diversified and retailers cannot easily just up and relocate to a smaller unit. Their goodwill will be tied to the location and finding a suitable alternative unit will be difficult. Moving is farther down their list of options than for office tenants, and this leads to greater income security for the landlord."

If retailers do go under, then often others will take their place, according to Andrea Pavelka Schimmler, national director in investment strategy at LaSalle Investment Management. "It is true that this economic downturn is unprecedented and there have been failures, but that is the evolution of retail. What we are seeing in the UK, for example, is those with stronger concepts, such as [upmarket food retailer] Waitrose moving into outlets that have been vacated by Woolworths, particularly in prime high street locations."

This is because consumers are still spending, albeit less and more selectively. Paul Sanderson, head of EMEA research at DTZ, says: "Looking at the conceptual make-up of the retail market, the luxury-end brand name stores have held up relatively well, as has the lower end of the market, which includes the likes of Primark, Aldi and Lidl, and some large supermarket chains, such as Tesco. It is those in the middle that are suffering."

He adds: "Looking ahead, though, we will see this environment continue to expose any retailers, such as Woolworths, which do not have a strong business model or clear brand and market positioning."

Not surprisingly, it is difficult to make sweeping statements about Europe due to the different characteristics and shopping habits of each country. One common thread is that transactions have dropped and yields have widened across the board. In February, CBRE released figures that showed European retail investment activity fell by 45% in line with other areas of commercial real estate. However, the company's most recent numbers show European retail held up better, in terms of investment activity, during the first quarter of 2009 compared with other commercial sectors. Overall investment turnover fell by 44% quarter on quarter, but retail property sales dropped just 7%. Furthermore, two of the four European commercial property deals over €1bn in 2008 were in the retail space: the €2.7bn Steen & Stróm portfolio in the Nordics region, and the €2.3bn Karstadt Portfolio across Germany.

That said, due to their size and the difficulty in obtaining funding, the European shopping centre segment was hard hit last year. The final transaction tally at the end of 2008 was a seemingly mere €11.5bn, down from €27bn in 2007, while its total share of the retail investment pie slumped to 38% from an average of 50% the previous year.

As for the actual investors, Sanderson of DTZ points out that overall activity from cross-border purchasers was less prominent in 2008 than in previous years. For example, in the fourth quarter of 2008, these deals accounted for 29% of the total compared with 55% during the corresponding quarter in 2007. Private property vehicles were the most dynamic players, with the UK, French, Dutch and US investors leading the pack.

The general consensus is that the fallout will continue, with secondary and tertiary properties the most likely to suffer further pain. CBRE figures show that the yield shift, which accelerated in the fourth quarter of last year, in both high street retail and shopping centres, was roughly the same - an increase of around 16% from the peak of the market in mid-2007. The average prime yields in the 27-country eurozone in the fourth quarter of 2008 were approximately 5.5%, which is still less than other sectors. Industry reports note that the yield correction was sharper in the region's office area, with average prime coming in at around 6.5%, while secondary properties reported 7.2%.

As is to be expected, there were variations by country, with Germany, which follows conservative lending practices, reporting the smallest shift for prime retail product of all the major cities of just about 25-40 basis points. By contrast, the UK and Ireland, where valuations had ballooned, have seen yields jump by between 175 and 285 basis points last year.

Although prices might seem reasonable, and some market participants would say now is the time to canvass the European retail scene, institutions are adopting a wait-and-see approach. "There is definitely a raft of money out there waiting to invest, but investors are being cautious and do not want to make any mistakes," Welham notes. "They are also hoping that there will be further falls in values, but as time goes on they will begin to realise that, against this low interest rate/volatile stock market environment, there are few places to invest their money. Government bond yields are at historically low levels and strong quality retail assets present good opportunities."

Alessandro Bronda, head of global investment strategy at Aberdeen Property Investors, also believes calling the trough can be tricky in any asset class, which is why it might be better now to climb back onto the retail rung of the property ladder. "One of the biggest challenges is to identify the markets which will do best in terms of future rental growth, especially if the downturn lasts," he says. "However, I would take a long-term view and start to look at opportunities. Investors may be able to negotiate good terms today for quality assets that factor in further price declines."

There is a mixture of views regarding specific asset classes and locations, but most agree that investors should proceed with caution and adopt a more realistic view about the sector's future performance. As Sanderson points out: "Investors will have to adjust their expectations. In the short term, weak or falling rents and further yield correction will depress returns. Although opportunities will certainly emerge as market pricing adjusts, future returns will be dependent on good stock selection and effective asset management. The days, though, of 15-20% returns generated during the boom on the back of falling yields are gone."

In terms of opportunities, the UK, which is the region's most developed retail property hub, may seem the obvious candidate, because its correction has been the most rapid and severe. Nervousness, though, persists and, to date, France and Germany, the Nordics and pockets of Central and Eastern Europe (CEE) are generating the most interest.

Andy Watson, head of acquisitions for southern Europe at LaSalle Investment Management, says: "It's always tricky to generalise, but if there was a nominal one to 10 scale of which countries have adjusted most in capital value, the UK would be at number 10 for adjusting the most, with Spain perhaps closest at seven or eight. On the other end of the scale would be Italy at two to four, while France and Germany would be in the middle."

He adds: "One of the reasons for retail investment being more defensive on the continent is that consumers here did not take on as much household or credit card debt, whilst planning permissions are also generally more restrictive. It could take, for example, 15 years to get planning permission in Germany or France to build an out-of-town shopping centre, because governments do not want to suck the life out of the city centre. As a result, there are less institutional grade retail properties in the market."

In addition, as David Skinner, director of real estate strategy and research at Aviva Investors, notes: "European retail assets can be quite difficult to acquire. A significant proportion of high street shops, for example, are owned by private individuals and owner-occupiers, while shopping centre ownership in some countries is dominated by relatively few specialist retail operators or listed companies, such as Unibail-Radamco and Klépierre. Many are buy-and-hold investors, and there is often little churn in the portfolios."

 As for central and eastern europe (CEE), the main countries - Poland, Hungary and the Czech Republic - have suffered the most, although Prague is seen as the most appealing city due to a healthy tourism trade and limited retail supply. Sanderson says: "The retail sector in some CEE markets obviously faces particular problems, given the severe economic problems faced by some countries in the region and potential oversupply in some markets."

He adds: "However, just as many of these markets became overpriced during the boom, as investors sought higher returns without paying full attention to underlying fundamentals, so the reverse applies now, with the region as a whole falling out of favour, despite the fact that both economic conditions and market fundamentals vary widely. Those investors who do the appropriate research should be able to take advantage of this by identifying attractively priced properties with good longer-term prospects for rental growth."

José Antonio Martín-Borregón, general manager, investment management southern Europe at ING Real Estate, notes: "In general, the focus with shopping centres has currently been on increasing vacancies, decreasing rents and unpaid rents. But it is important to note that there are distinct differences between them and investors need to look more at the micro-stories. For example, the Colombo and Vasco da Gama shopping centres in Portugal are still performing much better than secondary shopping centres in countries whose economies and consumer shopping have not been as badly affected."

The same is true with high street locations, says David Rendall, chief executive officer for European operations at Cushman & Wakefield Investors. "Prime retail such as Bond Street in the UK and Champs-Elysées in Paris are always attractive. Overall, investors have to realise that they have the opportunity today to buy prime core assets at reasonable prices. If they wait too long they may miss the boat. It is important to take a long-term view and be selective in terms of the covenant risk and the retail pitch. For example, an investor would not want to buy an antique shop in a mass market street; the outlet needs to be complementary with the other shops on the street."

There has also been talk of distressed assets, but so far the significant repricing of assets, particularly in the UK, has not led to a comparable volume of fire sales.
Currently, sellers and lenders are not under pressure to offer deep discounts, because the banks have been willing to renegotiate with property owners, especially those endowed with a strong track record. The tide may shift in 2010 or 2011 due to a combination of factors. Not only will a large chunk of short-term commercial real estate loans be reaching maturity, but commercial property prices might also be nearing bottom, and investors will have a clearer idea of the effects of regulation.

"A lot of capital has been raised for high risk strategies, but little has been spent yet," says Skinner. "This is likely to change through the course of the year. I expect to see investments in direct property, in distressed bank loans, in indirect vehicles that are coming up against their loan to value covenants and need an injection of new equity, and in listed property companies that have not managed to raise new equity to date."