AnalysisRetail property

Retail Property challenges are partly about technological advances

In the Retail Property Sector, in recent times, much has been made of the challenges facing the sector emanating from the emergence of online shopping. To be sure, the onward march of technology is affecting virtually all sectors of the economy, and a greater reliance on online retail in future is a very real challenge to the Retail Property Sector, forcing it to “re-invent” itself in various ways.

But in many ways, the more things change the more they stay the same, and old fashioned economic and Consumer fundamentals are as much a challenge to the sector, as the Consumer Sector goes from being an “outperforming” part of the economy to “just another sector” status.

In addition, the retail space affordability challenge has become far more acute in recent times which, it could be argued, contributes in part to a drive to cheaper retail alternatives (including online retail), because retail space affordability has deteriorated sharply over the past 2 decades.

We examine just how far the property affordability deterioration went over the past 2 decades or more, to find that the Retail Property Market, the outperformer by a long way, has seen its affordability deteriorate far more than has been the case in Industrial or Office Space.

Long Term Capital Value Growth

According to MSCI South African property data, since the mid-1990s the increase in all major commercial property segments’ property values has been quite spectacular.

Even the seemingly perennial underperformer, the Office Property Market, has seen its capital value per square metre increase cumulatively by a massive 511.7%. Industrial and Warehouse Property has exceeded that, recording 612.6%, while Retail Property is far ahead with a cumulative increase of 883.3%.

We then convert the capital value per square metre time series to “real” terms using the GDP (Gross Domestic Product) inflation (GDP deflator) measure of economy wide inflation.

Using a real capital value measure we still see that especially Retail Property has become far more valuable than just over 2 decades ago, growing by 110% from 1996 to 2018, thus more than doubling its real value on that of 1995.

By comparison, Real Industrial and Warehouse Capital Value/square metre increased by a lesser (though still strong) 52.2%, and Office Space by 30.6% in real terms.

In short, all commercial property/square metre values became significantly less affordable over a 23 year period from the 1995 base year, but Retail Property’s affordability deterioration was far more extreme than the other 2 major categories.

Operating Costs have escalated sharply too

For the tenant, though, it is operating cost/square metre that is a more relevant number. Here, too, we have seen sharp cumulative growth over the 23 years, Office Space operating cost/square metre rising by 461.4% to 2018 compared with 1995, that of Industrial Space by 805.7%, and that of Retail Space by an extreme 975.7.

A major portion of operating costs is the various municipal rates and charges, and utilities tariffs, notably electricity. Therefore, we saw the steepest increase in operating costs around the period 2009-12, the period around the time where electricity utility Eskom implemented sharp multi-year tariff hikes. Municipal rates and charges, and non-electricity tariff increases, have also been significant.

In real (inflation-adjusted) terms, Retail Property saw its operating cost/square metre rise by 129.7% (compared to 93.4% in the case of Industrial Space and a far lesser 19.9% for Office Space).

For a long time, however, tenants could absorb strong operating Cost and rental increases

A very strong consumer period, especially from around 2000 to 2008, enabled retail tenants to absorb strong operating cost and rental inflation for much of the time.

But alas, rental and operating cost growth well in excess of general inflation would ultimately create affordability problems for tenants in a stagnating economic environment, and start to exert downward pressure on property income growth.

And indeed, we have seen real retail net operating income growth fail to reach its 2007 multi-decade high again, the year when it peaked at 110.3% higher than its 1995 real level. In 2018, it was still -4.5% down on its 2007 real high, and starting to decline once more after some earlier recovery following the 2008/9 recession period dip.

At 100.7% above the 1995 level, real net operating income is still relatively high by historic standards. However, the tenant population is increasingly financially constrained in a weak consumer environment.

This poor retail space affordability arguably contributes to the drive to seek cheaper retail alternatives by the Retail Trade and Catering Sector.

Much has been made of the advent in online retail and the challenge it poses to traditional retail property, requiring much reinvention from the latter. We also know that this comes at a time when retail sales growth is under pressure due to a financially constrained consumer. But the further challenge, which we have attempted measure here, emanates from a sharp retail space affordability deterioration over the past 2 decades or so, driven by a very strong retail property market period until not too long ago.

The fact that retail space affordability has deteriorated significantly over the past 2 decades or so likely contributes in part to the drive to find more affordable retail alternatives regardless of technological advances.

More affordable alternatives do include the shift to greater use of online retail, but also include traditionally cheaper retail trade and services alternatives (compared to the large “regionals”), which include the smaller community or neighborhood centres, or even retail warehousing.

This would lead to the expectation of a “relative outperformance” of the smaller sized categories of retail centres over the larger categories in the near term.