Pandemic could accelerate UK retail property investment shift

A growing number of retail landlords are now considering converting their leases to replace the traditional upwards-only rent review mechanism with rent based on turnover. If carried through, this would represent quite a shift in the investment proposition, as the landlord would effectively be sharing the operational business risk.

Many of the trends that we have seen as a result of the pandemic are not new, with lockdown simply accelerating the pace of change. In the retail sector, consumer spend has been migrating online for some time leaving those without an 'omnichannel' offering struggling relative to their peers. At the same time, demand for logistics and fulfilment space has buoyed investment in this area, while occupiers of office space have been looking for increased flexibility in their fixed property costs as more office workers embrace agile and flexible working arrangements.

In my recent article on the role of alternative real estate assets in the coronavirus recovery, I suggested that alternatives, such as build to rent and later living, may hold some of the solutions to the difficulties in the retail property market. We have already seen investors get comfortable with operational business risk in the context of these assets, although replicating this model in the retail sector would be a significant further step.

Presumably, if landlords adopt this approach for retail properties, leases will include a turnover break, allowing the landlord to remove an underperforming tenant to make way for another occupier or to find an alternative use for the space. Turnover breaks may provide landlords with the flexibility that they need, although this would also seem to indicate an end to the security of tenure provisions afforded by the 1954 Landlord and Tenant Act in these types of arrangements.

Looking further ahead, could we see other sectors adopt a similar model, with the potential for office rents in professional services or other revenue-generating areas to also be linked to turnover? At the same time, given the desire by many investors to have access to the covenant strength of Amazon and other large online businesses, many new logistics developments are being funded by institutional investors on the basis of leases with inflation-linked rent reviews that are capped and collared.

Historically, real estate investment risk and reward has tracked somewhere above bonds and below equities. If the retail market, and ultimately certain parts of the office market, requires investors to participate in operational risk, yields should in time move closer to those of equities. In contrast, in logistics, where investors are benefitting from a secure income, yields should move closer to those of bonds.

Lenders will certainly be happy with the investment proposition in logistics but my hunch, based on my experience in the early days of the student accommodation sector, is that it will take longer for them to get comfortable with the operational proposition in retail and offices. There may therefore be a certain amount of their catching up with the market, should these developments proceed.