In my previous post I argue that few executives seem to be willing to risk real change, even if the future is clear. I also have previously argued (read previous post on Inside Retail to explain why this is imperative) that leases are being rapidly devalued. How should landlords respond?
Because the retailer suffers from fluctuating performance and because, right now there is a structural change to the retail sector driven by e-commerce, many retailers are experiencing margin convergence and considerable financial pressure.
Because of the high casualty rates, those who have survived have enjoyed being in greater demand and have experienced a re-balancing of relational power.
The ‘market’ will force alignment in the respective fortunes of the retailer and the landlord, so we have come up with clunky coping mechanisms to re-balance things by introducing friction costs.
The current system (with specialty leases) has considerable inefficiencies caused by the (a) different investment and performance profiles of landlords vs tenants, and the resultant friction costs. These retailers are sharing the friction costs (positive and negative) incurred to the landlord, but there is no such thing a free lunch – and ‘security of covenant’ has a hefty price.
The cost usually comes in the form of fitout incentives as landlords are investing heavily in start-up by funding fitout costs. And in the downturns, abatements increase. This is offset by turnover rents during the good times, which never seems to come around.
One solution is to adopt an ‘agile’ lease structure. (This is a topic that needs more explanation and some graphics that will be included in a future publication.) In brief, an ‘agile’ lease is one where the key commercial terms like (i) trading hours (ii) usage clauses (iii) rent (iv) covenantors etc. are treated as a set of clauses (a term sheet) that may change rapidly and frequently – allowing for some agility to innovate. Coupled with this, there is an agreed process to that allows for quick and cost-effective varying of this term sheet in response to changing market conditions.
The other parts of the lease (that hardly gets read) can remain fixed and is in place to manage risk, liability etc. However, by adopting a lease that is designed to accommodate adaptation and a process that is geared toward achieving that.
The first, obvious major objection is that it will turn the entire shopping centre into a giant casual leasing arena. And the perceived lack of ‘security’ of income will tempt you not to read any further. But there is a method in the madness.
Of course this is a hypothetical solution, and there is very material fact that the Retail Leases Act is perpetuating the status quo, leaving little wriggle room for actual innovation.
The reasons why AGILE LEASING won’t work that will be considered are:
- Retailers will lie about their figures
- It will be too hard to administer
- Retailers want certainty too
- Property investors won’t accept that as a risk profile
- It will make retail and retail property the same investment profile
- It will make the mall one giant, pop-up space
I argue that an agile lease structure would align return profiles and achieve key outcomes:
- It negates some of the advantage of investing retail property as opposed to direct retail investment
- But you gain /maintain strength by being able to have investment risk spread over multiple retail categories
- And you gain upside by being exposed to the latest/greatest concepts (without capital investment)
Some may argue that property investors want a certain risk profile. I argue that:
- The cost of de-risking for retail volatility is too big
- Retail property performance is tied to retailer fortunes anyway, this merely makes it more transparent
- De-risking investment can be done more effectively with share allocation/ index funds than merely relying on lag factors. (And, as soon as retailer start doing it tough, the good investment managers are probably factoring that into retail property investment prices well in advance)
Most challenges can be overcome if we want to do it and we have the technology to do it.
The inflexibility of the lease is a major inhibitor of innovation, and innovation is in real short supply at the moment.
The ‘market’ has a way of passing the costs around the system anyway, and a new structure of leases will remove/substantially reduce most of these friction costs from the system. And I would argue that the landlord is paying anyway – in lump sums – along the way. Formalising the agreement simply makes things more predictable and more flexible.
Embracing AGILE LEASING will give landlords exposure to innovative retailers – which is the growth engine of long-term sustainable returns.
With agile leasing structures asset managers in practice trade a counter-cyclical investment performance (or at least a lagging investment performance) with a lease structure that enables it to be at the Asset Level, what an Index Fund is at the investment level.
I don’t actually believe any landlord will (be able or willing to) embrace agile leasing completely. A career manager is highly unlikely to take such a risk and it is not something that can be modelled to suit decision-makers in a relatively conservative investment environment.
So why write about it and suggest it?
I believe that we can START. One deal, one centre. Succeed or Fail. Learn. Rinse and Repeat. Scale from there if it works.