What the discounted cashflow revolution means for UK shopping centres and leases

A “guest writer” article in React News by Mark Phillipson detailing how the new approach will rely on greater insight by the valuer to understand the business model of each tenant.

The UK shopping centre sector is poised to offer substantial opportunities to investors both current and new – but only if they can embrace a way of structuring leases which is aligned to the discounted cashflow (DCF) property valuation methodology which is set to become the norm.

Centres of all sizes are trading at historically low values and this offers an opportunity to access the sector at an exceptional price point. Of course, the reason that values are so low is that they reflect harsh realities of what has been happening in the sector – even prior to the pandemic. Declining rental values, rapidly increasing vacancy rates, increasing rates liabilities and the onerous cost of managing the assets are major deterrents.

These are the stark realities but there is a way of asset managing centres that can realign them with the strategic objectives of retailers. It is a strategy which can also embrace the DCF valuation methodology, which is being ushered in following the RICS valuation review completed by Peter Pereira Gray last year.

Getting real

Currently, UK shopping centres largely fall into one of three categories:

• Regionally dominant, super-prime fashion-led schemes, that now need converting to the outlet-style data-driven leasing model to grow rents
• Food-anchored convenience schemes that fit their local catchment
• Mid-sized schemes that are no longer relevant, which need to be repurposed to facilitate alternative use and town centre regeneration.

Transactions during 2021 indicate market pricing for the super-prime, regionally dominant schemes are currently between 8-9.3% net initial yield, illustrated by the sales of Manchester’s Trafford Centre to CPPIB, Touchwood in Solihull to Ardent, the 25% stake in Bluewater recently acquired by Landsec/M&G, and latterly Silverburn in Glasgow, which was sold to Eurofund at the end of last year. While appearing historically cheap, for returns to be realised that reward the real risks involved, the old methods of asset management simply cannot be relied on.

Contrary to what many asset managers are still telling their investors, there will be no bounceback to how things were before. The way forward is an approach to asset management which fully encompasses how physical stores contribute to both in-person and online retailing.

A good example of this is the way stores are increasingly used for fulfilling online orders. The value of the stock being moved through a store for online fulfilment can be the same – or more – than the sales being conducted across the counter. Landlords who are not using appropriately drafted turnover-related leases and who don’t have an asset management regime which closely monitors store usage are often unaware that this situation even exists.

Being able to have this holistic view of how a shopping centre and the stores within function is very much aligned with DCF valuation methodology and also the shorter leases that retailers are demanding.

Shorter and sweeter

Shorter leases and revenue-responsive agreements are here to stay, just as they are in most of Europe and North America – but investors need to understand how to engage with them.

Our view is that centres which relate most closely to their catchment by size and demographic will continue to attract very significant visitor numbers and still have a healthy future, especially off rebased rents with correctly drafted turnover provisions. However, this new environment will require asset managers to have a new skillset – which nearly all don’t currently possess – to assess centres as a buy, hold or sell.

The affordability of a location for occupiers differs according to their margins. So there needs to be a stronger, data-driven relationship between rent and turnover. This makes clear the affordability of a property to an occupier and the ‘effort ratio’ required for them to be profitable in it.

“This new environment will require asset managers to have a new skillset – which nearly all don’t currently possess – to assess centres as a buy, hold or sell”

Most shopping centre asset managers do not have the skillset or data infrastructure to deliver this dynamic form of analysis and management. It requires data systems and proven expertise in managing revenue-responsive lease structures.

The new approach to valuation

In this context, it’s essential to understand that traditional methods of valuation are no longer pertinent to retail destinations that feature a predominance of rental agreements based on turnover/revenue.

The DCF approach is far more appropriate to an operational income model, but will rely on greater insight by the valuer to understand the business model of each tenant, and greater transparency not only around the levels of turnover they are generating, but also their operating margins and any volatility.

It is critical that shopping centre asset managers really has true operational experience and insight to this equation to assist the valuers. Only those who have operated retail environments where turnover leases predominate will be able to provide this.