Hurry while stocks last

Investors are returning to Spanish and Italian shopping centres. Andy Schofield and Stefan Wundrak reveal there is a six-month window

Institutional buyers are returning to Spain and Italy, seeking to pinpoint the trough in the cycle. Prime yields for shopping centres and retail parks represent attractive discounts relative to the UK, Germany and France, where best quality assets command yields of between 4.75% and 5%. Spanish and Italian shopping centre yields are close to the top end of their previous cyclical range. The timing is now right to take advantage of yield-driven capital growth, despite the challenging macroeconomic environment. The recovery in prime yields will probably take place quickly, leaving a narrow window to invest.

The property risk premium for Spain and Italy is higher than for most other major countries in Europe. However, expected returns should compensate for the risk. Capital uplift will drive short-term performance as yields respond to lower risk aversion and rental growth will contribute to performance after retail sales and retailer confidence recover.

Incoming data suggest the economic situation in Southern Europe is stabilising sooner than expected. While this is good news, the consumer economies will struggle in the short term. Retailers are therefore targeting established centres and closing non-performing stores. In terms of vacancy and churn, however, there are wide variations in performance between and within regions, highlighting the importance of opportunity-led strategy.
In terms of stock-picking, large centres with affluent catchments are strongly recommended and only prime centres with stable passing rents should be considered. Dominant centres proved to be resilient over the crisis years and are much better placed over the medium term to lead the recovery in rental growth.

Private sector deleveraging in Spain has just begun, with financial liabilities amounting to 130% of personal disposable income in 2012. In Italy consumers have stronger balance sheets but incomes are nevertheless under pressure. As with Spain, residential owner-occupation is high, yet only 15% of the Italian population has a mortgage. As a result, Italy boasts the lowest proportion of household debt in Western Europe, amounting to just 85% of personal disposable income, compared with 142% in the UK and 91% in Germany. Italy’s woes are more structural in nature; since the early 1990s Silvio Berlusconi’s three premierships and short-lived governments with weak mandates have had very limited success in driving economic reform. Italy’s medium-term growth prospects will therefore be modest relative to Spain, where the implementation of banking and labour market reforms has made the economy more competitive.

Spain’s real personal disposable income has fallen by 14.5% since 2009. As a result, the household sector dipped heavily into savings to finance spending. Between 2000 and 2007, savings were steady, at 10% of disposable income, rising to 18% in 2009 as recession hit. Since 2009, however, savings have fallen to just 8% of income. In Italy, economic forecasters predict disposable incomes will have fallen by 10% by end-2014, so not quite as markedly as Spain’s. Italians have been keener savers, with household savings typically hovering around 15% of disposable income in the decade before the crisis, one of the highest saving rates in Europe. As in Spain, Italy’s saving rate recently reduced to 11.5% as a result of recession and falling incomes.

Forecasters predict that the turning point for household fortunes is in sight, providing inflation remains weak. The expected trajectory of recovery across the core European economies is illustrated in figure 1 and suggests large residual output gaps and weak inflationary pressures in Italy and Spain. A recovery in incomes and retail spending should therefore occur as employment levels stabilise, expected next year in Spain and the following year in Italy. Retail sales should stabilise next year with weak growth of approximately 1.5% pa between 2015 and 2017, before picking up pace in 2018. By 2017, the industrialised regions in northern Italy and Spain should enjoy similar growth rates in retail sales as those structurally comparable regions in Germany and France.

Sink or swim for retailers
The Italian retail market is sharply polarised along the lines of location quality. Prime shopping centre rents have remained stable since 2007 with international retailers competing for the best space. Tourism reinforces the trend in favour of top centres; about 44m people travel to Italy per year. European tourists have been complemented by an influx of consumers from Asian and Eastern Europe.

In the fashion sector, the market share of value retailers in Italy stands at 36%, compared with 59% in all of Europe. Aspirational retailers take 15% of space (in Europe this averages 8%) and luxury retailers 7% (European average 3%). In Italy, electronic retailers have been worst affected, especially with Amazon now breathing down their necks. Last year, fashion sales turned negative for the first time since records began, which says something in the world’s most fashion-conscious country. Food, and health and beauty are the only sectors where sales kept growing.

Retailers remain highly selective in terms of locational preferences. Most remain focused on the north and centre, with some retreating from the south altogether. Unlike Spain, Italy has experienced very few retailer insolvencies, as most major domestic brands have manageable levels of debt and the market share of international brands is high in the fashion sector.

Net new store openings in Spain have fallen significantly and those chains engaged in expansion are highly selective, preferring units only in the strongest malls. Non-performing stores are being closed – for example, Inditex has closed stores and have selective expansion plans. Despite the many casualties, new international retailers are appearing and there has been limited store network expansion. In Spain, larger chains (more than 25 stores) are experiencing modest sales declines but smaller chains and independent stores are struggling. Fashion sales have held up surprisingly well in shopping centres in recent years, but other retail categories have experienced marked declines in sales. According to PMA, market rents for Spain’s prime regional schemes fell by 4.8% in 2009, stabilised in 2010 and 2011, and grew by 5.8% in 2012, proving that the best schemes can withstand the challenging consumer climate.

The picture has been less rosy in the rest of the market where average shopping centre rents have fallen year on year since 2009, a one-third cumulative fall. A similar story is evident with vacancy and churn rates. Super-prime centres such as La Vanguarda, Parque Sur, L’Illa and La Maqinista experienced average vacancy of just 3.5% last year but even in average prime schemes dominant within their catchment and with a good tenant mix and scale, vacant units rose to 9.2% in 2012.

Spain has 535 shopping centres, covering approximately 12m sqm of gross leasing area in mid-2013; Italy has 745 shopping centres with 13.7m sqm. In both countries the vast majority of centres were completed in the past two decades. Due to local planning approaches there are significant regional differences in provision, however, with Italy’s younger stock more concentrated in the south.

Regional variations in provision are significant in Spain: Madrid, Aragon, Asturias, Pais Vasco and Galicia in the north all have higher provision per head of population than the national average, while Catalonia and the Balearics have significantly lower-than-average provision. Some regions imposed planning moratoria in the mid-2000s, but these were lifted in 2009 when deemed uncompetitive by the EU. Completions fell sharply in Southern Europe after 2009 but, unlike Italy, the short-lived improvement in the economy in mid-2010 led to a number of schemes starting or recommencing in Spain. Spanish completions therefore rose sharply in 2012 at the height of the euro-zone debt crisis.
Some interesting facts emerge when each region’s total retail spending is compared with the provision of shopping centre space.

In Spain, the Catalonia region, with low provision of space and affluent catchment, and the Balearics Islands, with even lower levels of provision and even higher retail spending, look attractive. Both regions benefit from tourism spend.

Other regions have low retail spending but very low provision (for example, Extremadura) and look better placed than affluent Madrid with the third-highest provision of space of any region. Asturias combines very high provision with relatively low retail spending, so looks less appealing, while Aragon also has relatively high provision relative to the level of retail spend. Galicia looks reasonably well balanced between provision and retail spending. As we shall argue later, however, making broad-brush assumptions at the regional level can cause good investment opportunities to be overlooked.

Strong local catchments with favourable supply and demand balances can be found across Italy. Only the very small regions of Abruzzo, Molise and Friuli-Giulia appear generally oversupplied. The most favourable supply-demand characteristics tend to be in equally small provinces, such as Valle D’Aosta, Alto Adige, Trentino, Umbria and Basilicata. Among the more populous and affluent regions Veneto, Toscana and Emilia-Romagna stand out positively, with very limited provision per capita. However, Italy’s densely populated economic powerhouses of Lombardia, Piemonte and Lazio rank only average because high spending levels are matched by equally high shopping centre provision.

Institutional investors reappearing
The European debt crisis and ensuing recession left investors feeling nervous regarding Southern Europe. Given the economic backdrop, it is hardly surprising that overseas investors have shied away from the retail sector. The annual shopping centre-traded volume for 2012 reflected historic lows for both Spain and Italy.

In 2012 only €250m was invested in Italian retail – mainly domestic capital and overwhelmingly in prime high street assets, which are perceived as most secure. Potential investors were frustrated with sticky price levels, which hardly adjusted to the challenging circumstances.

In Spain there were little more than a handful of deals, none involving trading shopping centres. Many of the transactions conducted in 2012 involved private investors with no reliance on debt finance.

Over the past six months, as a result of pressure exercised by banks, the need to sell (for example due to approaching fund expiries) has increased and, subsequently, asking prices in Italy have become better aligned with investor expectations. This has led to an improvement in liquidity in 2013, even though only opportunistic investors or institutions targeting long investment horizons are really active in the market. Since March 2013, the Qatar Investment Authority, Norges Bank, Morgan Stanley, Blackrock, AXA Real Esate and Allianz have re-entered the Italian market across all sectors, including retail.
Increasingly lower prices start to appeal to core investors, for the risk of a euro-zone exit is perceived as a remote tail risk. It also is driven by a need for diversification and hunt for yield, in particular in order to bolster the very low initial yields currently available in core European markets.

In Spain, private equity buyers are ever present but seek sizeable discounts on good quality assets where the seller is distressed. The banks have so far shied away from trading and the mismatch between buyer and seller expectations is a key reason for the lack of activity in recent years. Institutional investors are now returning and a couple of deals in late due diligence should set the tone for prime shopping centres and retail parks.
The assets are owned by CBRE Global Investors. Urbil, San Sebastian, (a 20,000sqm fully let urban scheme) is being acquired by UBS Global Asset Management on behalf of EON at a 7.5% yield. The lot size is €62m and no debt is required. Parque Principado – Asturias (a 120,000sqm prime regional scheme) is being acquired by Intus CSC in a joint venture with the Canadian Pension Plan Investment Board (CPPIB), reflecting an initial yield of 7%.

Spain and Italy shopping centre yields are close to the top end of their previous cyclical range, as illustrated in figure 2. The timing is now right to invest in order take advantage of yield-driven capital growth. The recovery in prime yields will take place quickly, ahead of economic stability and the recovery in retail sales, perhaps leaving a narrow six-month window to invest.

Purchasing at a net initial yield of 7% would generate capital uplift if yields were to stabilise at their 12-year (2000-12) averages. Rental growth should also contribute to performance, especially towards the latter years of the decade. According to CBRE, prime shopping centre rental growth averaged 5% pa in Barcelona and 8.6% pa in Madrid, prior to the crisis (2000-07). Clearly, this coincided with the strong growth in retail sales; in fact, average retail sales rose by 5.4% pa between 2000 and 2007, or 3% pa when adjusted for inflation.

Over the next decade, retail sales are expected to grow by 2.8% pa, or 1.5% pa when adjusted for inflation. If prime shopping centres experience half the ERV growth achieved prior to the crisis, then growth of 2-4% pa is possible further out. Combined with an attractive income yield and potential for yield-driven valuation uplift, expected returns should be very attractive.

The estimated required return on Italian and Spanish shopping centres is relatively high compared with core EU markets. This is partly explained by the bond yield, which Oxford Economics anticipate will rise over the long term and remain among the highest of the major economies. Figure 3 sets out Henderson’s estimates of the required returns by country for shopping centres.

The combined property level risk premium for Spain and Italy is higher than all other major countries in Europe with the exception of Portugal. However, given current property yields and the attractive outlook for capital growth, expected returns should comfortably compensate for risk. Depending on the length of the hold period, the required return might be considered lower, particularly if volatility and liquidity are less important.

Andy Schofield and Stefan Wundrak are directors of research, property at Henderson Global Investors