In the face of declining retail property values and highly leveraged companies, a new structure might be needed

Real Estate Investment Trusts (REITs) have been a huge success globally, providing an income-producing, liquid, tax-efficient structure for investors to participate in real estate. The key to their success is the high dividend pay-out ratio, which provides an ongoing cash return to shareholders. Globally, shopping centres have been the key asset class of some of the largest REITs, and indeed the sector has been structurally overweight in shopping centres. Why so? Because shopping centres are multi-tenanted, large assets, requiring ongoing capital expenditure, producing historically stable cash flows, and asset management opportunities. As such, they were ideally suited to both asset owners and investors.

However, two UK REITs (Intu and Redefine) have recently announced that, due to currently high leverage and declining retail property values, they would cut their dividend to preserve cashflow. In traditional corporate finance theory, which looks across all 11 equity sector groupings, there is some debate (i.e., conflicting evidence) as to the importance of dividend pay-out ratios on corporate valuations. However, for a REIT, there can be no such debate. The fundamental purpose, and indeed the reason for the tax efficient REIT structure, is that a high, fixed percentage of taxable rental income is paid out to shareholders. To cut the dividend, albeit potentially temporarily, is therefore an admission that the vehicle is no longer capable of producing cash (i.e., dividend) income returns for shareholders. At a time of declining property values, and thus declines in forecast net asset value, the dividend pay-out has traditionally provided an anchor, or floor, for the equity valuation. Removing this floor changes the nature of the equity from an income producing REIT, to a non-income producing option. Therefore, the question becomes; is this part of a wider problem regarding corporate structure, or is this merely a couple of examples of over leveraged companies operating in structurally declining markets, with over dependence upon weak covenants?

Given the divergence in performance between sectors, particularly retail and industrial, and indeed in the parallel asset pricing model,between the listed sector and the direct market, it is worth examining whether REITs are the appropriate structure to hold UK shopping centres.

The alternatives can be broadly split into the following binary categories:

• REIT/PropCo.
• No Leverage/High Leverage.
• Open Ended Fund/Closed Ended Fund.
• Perpetual/finite Life.
• Core/CorePlus/Value Add/Opportunistic.

In the current UK environment five factors are known:

1. The retailing environment remains tough, putting further pressure on tenants ability to pay. As such, most landlords are now publicly forecasting an increase in CVAs and a rise in vacancy rates. Short term income is therefore under pressure and cannot be totally relied upon to service either interest or dividend payments.
2. Valuations are declining, putting further pressure on LTV ratios. This is a UK, sector specific issue, and the trough in generic valuations is believed to be a way ahead.
3. Most shopping centre landlords now have an ambitious disposal programme in place so there is a surplus/oversupply of investment stock to buy. Although it should be noted that the ‘crown jewels’ are not yet being marketed formally.
4. The value of a lot of schemes lies in the alternative use, particularly in residential rather than retail. However, planning applications have only recently started to go in and the transformation from shopping centre to mixed use community centre is a long one.
5. The change in demand from tenants for shopping centre units in aggregate has peaked, and a structural, not cyclical, adjustment to the supply of retail space has only recently begun.

Given these factors, it would appear a REIT structure or an open-ended fund structure is not the best wrapper to hold these assets in. However, what would be attractive to investors is an ungeared, finite life fund, with no legacy issues and an imaginative, entrepreneurial management, who could acquire shopping centres on an opportunistic basis. The strategy would be to either recycle them post-repositioning or transfer them to a passive vehicle once the income had been stabilised again. In particular, a key part of the value creation would be repositioning away from pure retail to mixed use. There is a precedent for this approach in the Asian developer/REIT market, which separates out the risk/reward profiles of a high dividend pay-out company owning stabilised income-producing assets, and a developer who retains a maximum percentage of profits and recycles capital constantly. As the investment proposition of UK shopping centres has shifted fundamentally, so too has the appeal of the single sector REITs who hold them. It seems only appropriate that a new structure, more appropriate to these changes occurring in the market emerges, to maximise what is a significant opportunity to change the nature and investment appeal of these currently unloved assets.