High-end retail has weathered the storm well but it must widen its appeal if it is to stay competitive, as Beatrice Guedj and Richard Barkham report

Retail is ‘flavour of the month' again, say recent INREV surveys. Historical evidence demonstrates that retail has provided attractive risk-adjusted returns over time, and core investors with long-term liabilities are comfortably riding cycles, investing in ‘core' products with low long-term volatility.

However, with household deleveraging across Europe and fiscal constraints dampening potential spending, research is required to identify those retail submarkets set to outperform. Therefore, focus is on wealthy catchments in order to secure steady and higher cash-flow growth in the medium term.

The high-end submarket is a core asset class given its collective attributes, and more specifically its scarcity. The luxury submarket also provides a good insight to potential consumption trends as well as being a good indicator to potential changes to the retail landscape. High-end translates as a concentration of luxury brands, while luxury goods tend to be more volatile, given their high elasticity to income. Investors often consider luxury tenants to have stronger covenants.

During the downturn, no notable downward rental adjustment was observed for the luxury sub-market. Evidence of slight downward adjustments mainly relates to specific locations - Champs-Elysées in Paris, Serrano in Madrid, Corzo Venezia in Rome. It should be noted that streets with a mix of luxury and mass market brands are still considered high-end given their historical profile, although their characteristics are slightly different as more ‘chic and cheap' brands have snapped up premises vacated by domestic luxury brands. Rent stabilisation in pure high-end - Avenue Montaigne and Rue du Faubourg Saint-Honoré in Paris, as well as in Via Montenapoleone or Via della Spega in Milan - still has large commercial incentives as most luxury brands have not yet recovered the large losses in past turnovers.

In terms of yield, divergent trends have also been observed across the spectrum, from high-end to prime locations. Not surprisingly, quicker and sharper downward adjustments have been seen in countries with a negative wealth effect, such as Spain and the UK (reflecting outward yield shifts from 200-250bps). Conversely, pure high-end - with clustered luxury brands - such as New Bond Street, or Paris's Golden triangle have shown greater resilience in terms of capital value falls in the wake of lack of supply and liquidity.

Investors chasing retail assets in continental Europe are now focusing on the high-end market for upturn, as those markets usually recover quicker. Expectations have been fuelled by strong earning results released by luxury groups over the past few quarters: increased sales as well as in margins have driven share prices to a new high. However, this strong performance mainly relates either to diversified groups that are consolidating their presence in emerging markets or luxury brands that have benefited from favourable currency movements.

As the capital market recovery gains pace, yields have hardened strongly in the UK and to a lesser extent in Spain. Nonetheless, recent capital value gains in high-end (New Bond Street) and prime UK locations (Oxford Street) seem to be driven by rental value recovery, which is not the case in Spain. In the UK, capital values are now higher than during the previous peak, while in Spain, uneven trends are observed across the cities, districts as well as high end sub-sectors.

Luxury retail capital value in France and Italy has not yet seen any rebound, probably because of the minor downward adjustment observed during the downward phase of the cycle: -20% in the Golden Triangle and Milan's Golden Quad, compared with -25% to -30% for Spanish equivalents. Fundamentally, the absence of strong rental growth has likely dampened a rebound in capital values. But things might change as the investment fever in the UK is spreading quickly across continental Europe.

Looking at fundamentals, the fashion industry in continental Europe has not fully recovered as suggested by the global turnover in these countries. Although in positive territory, national figures are still weak and are far below past trends. As taxes are set to rise until 2012, particularly for high-net-worth individuals (HNWI), effort ratios may remain high for luxury brands. Although HNWI tourist spending can sustain overall turnovers, they might not be enough to sustain a double-digit rental growth recovery.
Luxury groups with a wide product range will continue to benefit from diversification.

The low entry price goods range has allowed them to broaden their consumer base and recapture cautious and non-loyal consumers. Conversely, pure luxury brands with a less diversified product range are now trying to decrease their entry price by providing new
supply. The big winners during the downturn have been the high-turnover fashion retailers, which provide fashion items labelled between luxury and mass markets brands. More generally, share prices relating to large chic and cheap groups have followed or outperformed luxury.

The structural landscape for high-end retail is changing, with mass markets and high-turnover retailers willing to pay for prime locations. While some luxury brands have reacted to this by broadening their customer offer, many have frozen their expansion in continental Europe to focus on the bigger appetite for Asia. Cheap and chic brands now have more freedom to conquer the super prime locations.

We expect tight supply to continue over the medium term, enhancing capital value growth. This will be checked by less tenant competition acting as a brake on rental value potential. Luxury brands might be less willing to pay top-dollar because of the invasion of cheap and chic brands on their doorsteps, compromising image and the flow of HNWI traffic.

Beatrice Guedj, executive director - research and strategy, Grosvenor Fund Management CE; Richard Barkham, Grosvenor Group research director