Real estate finance: a 'structural' change to financing retail in the UK

The retail market continues to dominate headlines in 2019, with a number of high-profile administrations and a continued stream of company voluntary arrangements (CVAs). With the sector undergoing permanent change and pressure likely to continue, the real estate finance industry has to adapt.

Fundamentally, the main challenge in retail comes from the growth of e-commerce and a move away from bricks and mortar shopping. Local Data Company data suggests that one in every £5 is now being spent online, compared to one in every £10 in 2013. Retail footfall is on a steady decline, as digitally savvy (and time strapped) customers make more purchases through the click of a button.

What’s more, with around 850 shopping centres in the UK, there is a significant issue of over-supply and, in a number of cases, underinvestment. According to the Local Data Company, a net 7,550 retail units disappeared in 2018 with retail vacancy rates continuing to rise in H2 and ending the year at 12.7 per cent.

However, the whole sector isn’t suffering. Generally, high end/prime (ie destination shopping centres and tourist hotspots) and discount/convenience (Aldi was the fastest growing retailer in 2018 and Primark doesn’t even have an online presence) are continuing to do well. It is the town centre ‘generic’ retail that has been the hardest hit.

But changing the way we shop isn’t the only factor – Brexit uncertainty, business rate hikes, rising wage costs and falling consumer confidence have each contributed to the difficulties in the sector.

So what can be done?

The Loan Market Association recently held a panel discussion on the subject - the significant take-away being that the changes we are witnessing are 'structural, not cyclical' and that stakeholders need to adapt and be flexible. From the property manager’s perspective, keeping units occupied is key, whether that means agreeing to ‘pop-ups’, turnover leases or other flexible terms.

Redeveloping and repurposing retail space to create a multi-purpose destination experience (where people want to spend time) is crucial – ie the rise in 'shoppertainment' – where retail and leisure are integrated. There’s no one size fits all – whether it be residential, leisure, community or lifestyle – and, in each case, the dilemma for landlords is that they may need to increase spend just to stand still.

The upshot for lending

The most recent UK Commercial Property Lending Report from Cass Business School reported that retail’s share of the sector dropped to 15 per cent of loan books in 2018 (from 20 per cent in 2017), as asset values declined and lenders reduced their exposure. Average pricing increased substantially – 19bps to 233bps for prime assets and 49bps to 334bps for secondary assets – making secondary retail the most expensive asset class to finance (cf office and industrial). Average loan-to-value covenants for retail were 57 per cent (prime) and 56 per cent (secondary), although a fall below the 50 per cent mark is expected.

At the moment, borrowers with properties that experience distressed retail tenants can face the perfect storm of cashflow trouble and breaches of financial covenants. Valuations often lag behind the real time impact on tenant covenants. Accordingly, we are seeing lenders react cautiously – willing to work with borrowers through periods of distress but often frustrated with the lack of transparent reporting of underlying turnover data and other metrics that would allow for adjusted covenant settings favourable to the borrower.

In terms of new lending, lenders looking for traditional assets with long leases and predictable income streams may find sourcing opportunities challenging. Yet, in order for lenders to accept more short-term ‘net operating income’ based underwriting, more focused reporting and a rebalancing of valuations is still required. Refinancing (Savills identifies 2020 as the property market’s financing spike) is where liquidity will prove most problematic. Alternative lenders looking for higher risk/return may fill some of this space, although this is unlikely to fully bridge the gap. Whilst we have seen the flexibilisation of covenants where interests are fully aligned, these issues remain a tough battle ground for the different stakeholders, both at the outset of new transactions in the current retail climate and during restructurings of legacy deals.

Credit committees are highly cognisant of the risks in the sector. The trend towards cautious underwriting is further borne out by the regional differences in current lending activity, with London being favoured over the regions. Still, for the right asset in a desirable location, the investment case remains much more promising - particularly where the borrower has a stellar business record and the property has alternative use or (cost-efficient) development opportunity.

It is clear that the difficulties in retail are not going away any time soon, with store closures, CVAs and administrations set to continue. However, the market is not dead – it is evolving. Through structural change and rebalancing, the sector is still generating opportunity.

Our firm is covering all the bases in this space (including our cross-practice work advising House of Fraser, Debenhams on the largest ever CVA, and Cale Street on an innovative transaction with Intu). If you would like to find out more, please get in touch.