Real Estate Executive Report 2009 - Still Standing

FOREWORD Welcome To The Third Deloitte Real Estate Executive Report On 16 September 2009 we marked the one year anniversary of the collapse of Lehman Brothers and the incredible impact this event had on the world economies. Despite the stock market rally in the last six months and consensus expectation of a return to weak economic growth in 2010, we do not believe there is any cause for complacency when looking at the prospects for the real estate industry. In a world where we have received a serious lesson in how hard it is to make accurate predictions, we can only say one thing with absolute certainty – that the future for real estate will be significantly different to the past.

In this third edition of the Real Estate Executive Report, we have asked our industry specialists to consider those key elements of our industry which appear to have been altered for good by the changes in the UK and world economies.

Richard Hyman is one of the UK's leading experts on retailing, having analysed, commentated and advised on the sector for 30 years, and is now an adviser to our Consumer Business practice. We sat down with him to talk about the ways in which the retail industry has been altered by the global recession and what this means for retailers' relationships with their landlords. Richard shares insights on consumer demand, retail space requirements and the competitive forces currently in play, which he believes will impact retailers in fundamental ways, possibly permanently.

A key factor in determining the future of the industry will be the availability of debt finance and the attitude of the key debt providers towards real estate. Our Debt Advisory team discusses the significant issues currently dominating the debt markets, looking at underwater bank loans, regulatory requirements, the impact of new accounting rules, new debt providers entering the market and the changes wrought by Government intervention. There may bargains to be had in the UK property market at present, but investors seeking UK property exposure by traditional means could find those routes blocked. We expect that an innovative approach will be needed from traditional property investors, fund managers and, of course, the nationalised banks, in order to drive increased activity.

Widening the focus to the industry as a whole, we have asked our Real Estate Solutions team to comment on their expectations for the shape of any potential recovery for the real estate industry. Will it be one of the much vaunted V, W or U shaped recoveries, or most likely none of the above? There is a clear challenge facing all real estate professionals in determining the shape and direction of our industry in the years ahead. Deloitte research into past recessionary trends suggests worryingly that our industry has perhaps a way to go to reach the bottom of the cycle.

Finally, when the 'music stops' after any period of strong economic growth it often creates situations where individuals feel pressurised to do 'whatever is necessary' to secure new business opportunities, in order to get ahead of their competitors. We discuss the factors management teams need to be aware of with regard to the risks of becoming involved in bribery and corruption, consider the reputational damage that can result if such risks are realised, and highlight recent regulations that have been put in place in the UK and internationally, to police this aspect of corporate behaviour.

We hope you find this publication useful and welcome your feedback on the contents. Please contact me or any members of our Real Estate team listed on the back page.

Best wishes. Richard Thornhill Editor & Real Estate Capital Markets Director

AN INTERVIEW WITH RICHARD HYMAN Richard Hyman is one of the UK's leading experts on retailing, having analysed, commentated and advised on the sector for 30 years. He founded Verdict Research in 1984 to carry out retail research analysis and consulting. In September 2005 he sold the company to Datamonitor. Two and a half years later he joined Deloitte as an adviser to its Consumer Business practice. Here Richard Hyman talks to James Whitmore, Deputy Editor of Property Week, about the fundamental changes that are taking place in retailing and the implications for real estate.

It Appears As If The Recession Is Hitting Retailers Hard. What Is Really Happening In The Retail Sector? This recession is the worst that any of us have ever seen and it is having a profound effect on retailing, but it would be a mistake to think that all the pressures on retail are being caused wholly by the recession. That is far from the case. Once this recession is over, the economics of retail will not return to where they were. In my view, they will never return.

Why Is That? The key reason is that we have had 30-plus years of relentless capacity growth in UK retailing. And in the last ten or so years of that 30-year period we have also had the emergence of the internet as a major new retail channel. The internet has not persuaded consumers to spend any more than they would have spent. It has cannibalised capacity that was already there.

Over the last ten years UK retail has added, net of closures, 100m square foot of new 'floorspace'. Half of that is traditional, bricks and mortar square footage. The other half (if you apply an average sales per sq ft to total sales, to get a proxy for physical floorspace) is through internet 'virtual' floorspace.

This additional capacity represents an increase of around 22%. That is a very large figure. You cannot increase the capacity of something ad infinitum; sooner or later the laws of diminishing returns will kick in – unless demand grows ahead of capacity growth.

Which Is What Has Happened? Yes, for most of the last 30 years demand has indeed grown. But we have reached the tipping point now and it happens to have coincided with a recession. Sales per sq ft are lower now than they were last year, and last year they were lower than they were in 2007. I believe they peaked in 2007. While they may not necessarily carry on falling as far as the eye can see, I think that the likelihood of them returning to where they were is remote.

Supply Has Soared And Demand Has Started To Drop – That's Not A Recipe For Success Is It? The change in the relationship between supply and demand is changing the economics of UK retailing forever and it implies a changing relationship between landlord and tenant. It's got to change. It remains to be seen how exactly it is going to change. Nobody knows for sure because we are in a state of flux.

What happens to retail economics is also going to be driven by the extent to which there is a significant shakeout in the number of retailers. Despite all the headlines and despite common perceptions, I think that far fewer retailers have withdrawn from the race than expected, given that this is the worst recession we have ever seen, there is far less vacant space on the high street than could have been expected.

Why Haven't More Retailers Gone Bust? Retailers have taken action sooner than they used to. A very good friend of mine, who is the Chairman of a national multiple retail business, has just gone through an administration process. Before, his company was making annual losses of £10 million and now he is making annual profits of £10 million.

It was painful because he worked very hard to build up his business but the administration process allowed him to restructure. An unviable business has been made viable, and many jobs have been saved. A number of businesses have gone through this process and have emerged in much better shape.

Has The Magic Wand Been Waved And Are They Now Fantastic Businesses? No. They are probably still quite weak from a trading point of view but they are now not going to go under. Another advantage of the administration process is that quite a lot of shops, Zavvi for example, went to the wall but virtually all their stores are now occupied by somebody else. It is very easy for the non-specialist media to be confused. They see a company with 400 shops go into administration and think that means that 400 shops have shut. Actually, more often than not, they are not shut at all. They may even be trading under the same name, or a more productive retailer has taken over the site.

What Has Happened To Consumer Spending? There are two contradictory stories. One is that spending has weakened considerably, the other is that it is a miracle that we are spending what we are. Spending has weakened considerably because people have got less money to spend. There are 2.5 million people unemployed. Retailing is a relatively low margin business, which means that it is all about scale and volume. You can have relatively small changes in the volume of sales, which have a very big, disproportionate impact on profitability.

Why Are People Spending What They Are Spending? It is true that it has held up remarkably well. For many consumers, lower mortgage repayments have relieved the pressure. However, some of this is going to be short-lived. Those changes are one-off benefits.

With Economic Figures Around The World Now Indicating That The Great Recession Is More Or Less Over, Do You Think Retail Is Over The Worst? I think we are not out of the woods yet. There is going to be a lot of optimistic talk. Everybody is desperate for all this to be over. Hence, the regular sightings of green shoots and that's in an environment where most people think unemployment is going to pass three million and that it will take until the middle of next year to reach that. How can we have a recovery that's worthy of the name, when so many people are losing their jobs? Even more significant is the knock-on effect on confidence because of job security. How many people feel secure in their jobs?

It may not get worse but I cannot see it getting better until the back end of next year, once unemployment has reached equilibrium.

When Things Finally Do...