Heads I win, tails you lose

The market has seen a surge in e-commerce - more recently via mobile devices and now by voice activation technology. This has been powered by consumers who are digitally-comfortable, convenience-focused and seeking choice at competitive prices.

The slow demise of Toys “R” Us is merely the latest casualty of the structural shift that is having a massive impact on both traditional retailers and commoditised retail destinations. Both are struggling to adapt to this fast-evolving environment.

Therefore, over the last few years it is no surprise to have seen high profile retail property owners spin-off or dispose of their more commoditised assets, either into new companies or into the private market.

Such spin-offs have generally followed slowing rental growth, disappointing earnings, significant stock underperformance and investor unwillingness to provide fresh equity or debt capital for assets that require significant defensive capital expenditure to maintain relevance.

Such restructures, which chop off the tail of underperforming assets, are expected to enable the companies to better adapt to the e-commerce challenge and changes in shoppers’ expectations of mall visits.

In order for malls to flourish and to continue to be as relevant as they have been historically, they must firstly be full of cutting edge retailers where customers wish to shop. This is a textbook approach that has unsurprisingly brought success over many decades.

Secondly, retail property assets must differentiate themselves by including a wide range of services and entertainment such as restaurants, bars and Tesla showrooms - through to gyms, indoor trampoline parks and even dodge ball courts at the extreme.

Although the operational reality is that although these experimental tenants pay lower rents, they do generate foot traffic. This enables the malls to become truly differentiated ‘experience’ orientated-assets - which are therefore less likely to be disrupted as e-commerce gains market share.

So what happens to the ‘tail’? The problem assets are packaged into a new company (Spinco) that may contain higher debt levels and often trades on much lower valuation multiples. This leaves behind a higher-growth business with lower debt and a higher credit rating - which trades on higher valuation multiples - enabling it to make new investments and return to growth.

The most recent example of this came in December when DDR Corp in the US announced that it would spin-off a portfolio of 50 second-tier shopping centres into a separate publicly-listed company.

The new company is called Retail Value Trust and will be liquidated over time with the proceeds returned to investors. DDR will retain 236 assets with prime demographics able to generate growth by investing to create attractive shopping experiences.

Similarly, Spirit Realty Capital in August announced plans to spin-off its more challenged properties into a newly listed US$2.7 billion company that it would continue to manage for a fee. This followed disappointing earnings following challenging financial reports from troubled retail tenants.

The high-growth Spirit Realty business that remains will enjoy a lower cost of capital and will realise US$400 million of cash from the spin-off to reduce debt, buy back shares and make acquisitions.

The last year has seen department stores such as Macy’s, Sears, Kmart and JC Penney announce store closures, while specialty retailers Wet Seal, American Apparel and The Limited have faced bankruptcy proceedings. These closures come as firms struggle to adjust their business models to the challenge of online disruptors that offer flexible delivery choices, such as Amazon.

This leads to falling rental revenue in those malls and shopping centres that depend on price-sensitive shoppers. This impacts the ability of malls to re-invest in creating an environment and facilities that will attract new businesses.

Moves by DDR and Spirit Realty Capital are just the latest in a series of similar spin-offs:

• Vornado Realty Trust spun-off 81 shopping centres and also four malls into Urban Edge in 2015 to focus on its Manhattan retail assets
• Taubman Centers sold seven regional malls to Starwood Capital Group for US$1.4 billion in 2014 as part of a capital recycling strategy to maximise net operating income growth
• In 2014 Simon Property Group spun-off 54 strip centres, which accounted for little more than 3% of its business, and 44 smaller regional malls into Washington Prime Group; to focus on larger malls accounting for most of its earnings and growth prospects
• In 2012 General Growth Properties spun-off 30 ‘B” Class shopping malls in typically second-tier regional cities, on which the management had invested less attention and capital expenditure for some time, into Rouse Properties;
  

Westfield was characteristically ahead of the game and creditably identified this trend many years ago. It was one of the first mall landlords to adjust its market proposition - a long time before it could impact the company’s operational performance.

When freed of these time-intensive but sluggishly-performing assets, management teams are better placed to deploy energy and capital into growth strategies that boost sustainable rents and asset values. However, the effectiveness of such demergers in addressing the challenges facing lower quality assets in areas of slowing population and economic growth remains unclear and requires careful analysis of the business models.

This represents an opportunity for listed real estate investors who take a long-term view and understand the structural shifting sands in retail property globally, to identify companies that are best able to navigate and capitalise on the e-commerce trend in order to capture long-term value for investors.