Shopping centre investment is dropping off as the market shows signs of strain, with falling yields and the prospect of a squeeze on consumer spending. Adrian Morrison investigates

There has been no shortage of pundits prepared to call time on the shopping centre investment market in recent months. But time and again their forecasts have proved premature.

Until recently, that is. Prices paid for secondary centres have dropped this year, because evidence of new deals showed yields moving out by 0.5 per cent or so. However, as markets peak, this is not an unusual scenario.

A more worrying trend is the difficulty several landlords have experienced selling prime stock. Property analysts forecast that British Land might have to shave £200 million off the book value of its Meadowhall shopping centre in Sheffield, before it is able to find a partner to buy up to 75 per cent of the scheme. Equally, Birmingham Development Company pulled its £330 million Mailbox and Cube scheme following a dismal showing after it went to market.

In the meantime, the shopping centre investment market is entering a hiatus, while landlords and investors try to gauge if these are extreme cases, or whether the prime market is in for a rough ride. The investment market could well be catching up with the retail market and experiencing a bit of a downturn. If this is the case, retailers could find themselves in unloved schemes.

“The change during the year has been more severe and happened more quickly than people imagined,” says Standard Life Investments shopping centre fund manager Ed Jenkins. “There has been a fair amount of stock withdrawn from the market because it has not reached asking price and most active buyers have paused for breath.” Standard Life Investments is not in selling mode at the moment, although Jenkins says this is because of the longer-term nature of its prime portfolio, rather than a reaction to present events.

However, the roots of the malaise – or correction, as many prefer to call it – stretch back to 2006. Last year was the first since 2000 to witness a drop in the value of shopping centre transactions. It was also the first year in seven when actively marketed schemes were withdrawn.

In its most recent Midsummer Retail Report, retail property agency Colliers CRE said that sellers’ aspirations are still in line with last year’s market conditions. While this is true, the malaise is equally because the investor’s love-affair with retail is waning.

Standard Life, Norwich Union, Scottish Widows and New Star have all changed their property fund pricing in reaction to redemptions from investors. The amount of cash going into UK retail funds is dropping while the amount being withdrawn increases.

The rapid change that Jenkins refers to is demonstrated by the secondary centre sales of West Orchards in Coventry and the Mander Centre in Wolverhampton, which both saw net initial investment yields soften by 50 basis points on comparable deals at the start of last year. Jenkins’ recent disposal of the Regent Centre in Hamilton, Lanarkshire, sold for the asking price, but it was a tough sell, he says.

“You now have to invest a lot more equity so you can grow rents. But the half-point movement in yields is not the whole story – quite a lot of centres will have moved a full point,” claims Mark Hunter, managing director of Hunter Property Fund Management, which runs three secondary shopping centres through its Active Retail Fund.

This is reflected in property investment analyst IPD’s June return figures for shopping centres. Its database of 250 centres throughout the UK shows that total returns – income and capital gain –for the second quarter of this year were just above 1 per cent, about a fifth of the value of any quarter in 2005. This is because of returns being based almost wholly on rental income, with little or no capital appreciation and, in some instances, depreciation.

“I don’t think shopping centres are faring any differently from any other property class. All properties, with the exception of central London offices, are being re-rated,” says Colliers CRE head of valuations Russell Francis.

Downward valuations, besides leading to lower prices on sale, causes income to get squeezed, makes it more difficult to borrow against the asset and reduces the net asset value of a shopping centre landlord.

The single reason cited more frequently than any other as the main cause is interest rate rises. Lending rates for investors that borrow money to fund shopping centre acquisitions have hit 7 per cent. This makes debt for the majority of private investors too expensive, because the interest they have to repay to the bank is more than the income they earn through rents. Yields may move out again, drawing in more debt-driven investment, but for the time being a vast swathe of recent investors are out of the picture.

Even if they could afford to borrow, because of rental growth prospects or the ability to take a greater equity stake, banks are far more cautious about what they lend and to whom. The collapse of the sub-prime mortgage market in the US reverberated into the UK and Europe, with central banks injecting billions into a creaking banking system.

The Catch-22 for many shopping centre owners is that one way of getting cheap financing for further purchases – securitisation – is no longer available: if the asset you are using to secure a loan against cannot be sold, it is no security at all.

Richard Akers, managing director for retail at the UK’s largest REIT, Land Securities, says: “Financial markets are volatile at the moment and, despite a huge amount of money waiting to be invested in property, that volatility has increased, led to interest rate rises and possibly damaged the perception of retail investment across the board.”

Tip of the iceberg?

The prospect of consumer spending falling away – despite the fact that it hasn’t happened yet – is also hampering shopping centre investment.

When British Land chief executive Stephen Hester admitted he would look at lower bids for up to 75 per cent of his company’s£1.6 billion Meadowhall Shopping Centre in Sheffield, he sent a shockwave through the world of shopping centre investment.

By doing so, he tacitly alerted the industry that prime shopping centre valuations are moving in a negative direction. Industry analysts started speculating that the centre might only be worth£1.4 billion. Hester cited the July floods, which shut the centre for six days and closed 66 of the 274 units for repairs, as the reason for the lack of interest from purchasers.

However, few believe that expenditure of£10 million on flood defences that, in all likelihood, will prevent a similar occurrence ever happening again, can lead to a£200 million downward re-rating.

Some believe British Land was too aggressive in its pricing strategy and didn’t account for the changing mood. But it has also been suggested that Meadowhall is the first example of prime shopping centres being hit by negative sentiment, as secondary ones have been.

Charlie Barker, partner of capital assets in property consultant Cushman & Wakefield’s retail team, concedes: “There has probably been a minor correction in prime shopping centre yields, but there is really no evidence to support that.”

On the contrary, most evidence points to values increasing since spring. Australian fund manager QIC bought a 50 per cent stake in the Merry Hill Shopping Centre in Dudley near Birmingham from Westfield. The£425 million price tag showed net initial yield movement in the right direction, at less than 4.5 per cent. Recent sales at the MetroCentre in Sunderland, West Quay in Southampton and Whitefriars in Canterbury all paint a similar picture.

Jenkins maintains that prime stock should hold its value, but there are conditions. “It is not sufficient to simply have a prime shopping centre,” he says. “There has to be a positive story in terms of active management or rental growth. The impact on secondary centres is increasingly putting pressure on prime stock that we and other landlords hold. But if you have a positive story, you have a robust defence against a fall in values.”

Assets with a strong competitive position, such as Henderson Global Investors newly acquired Whitefriars centre, which has 50 per cent of the town’s retail market and a good catchment, should maintain its initial yields of about 4.5 per cent. As should centres with development opportunities or towns with growing GDP or rising populations.

Francis believes things will settle soon. “In the next few months, re-ratings of shopping centres will have worked their way through and the market will be at a level more in line with prevailing interest rates,” he says.

Whether that level will settle below existing capital values is uncertain, although not altogether unexpected. But there is no doubt that total returns will be significantly less than the peak of two or three years ago. On a more positive note, any significant drop in values will stimulate investors into activity again.

Barker says: “The market is coming back to a more sensible place where sales are made because of property fundamentals instead of the ability to service a debt from an income stream. A return between 6 per cent and 8 per cent might be acceptable over the next five years.”