COVID-19: Accelerating structural change in the UK retail sector

Executive Summary

• Containment measures and changing consumer behaviour in response to COVID-19 have significantly impacted all UK businesses and will continue to do so for an extended period.
• Struggling retailers are looking to cut costs using the Coronavirus Job Retention Scheme and some are seeking to avoid or defer rental payments.
• The Coronavirus Act 2020 suspends the forfeiture of commercial leases due to non-payment of rent, but currently only until the end of June 2020.
• Landlords are businesses just like their tenants and shortfalls in rental payments will have business consequences for investors.
• Negotiations between landlords and tenants are critical for both parties during this time. They are reliant on one another to survive.
• COVID-19 is accelerating the natural selection process that was already occurring in the UK retail arena. There will be further insolvencies amongst the weaker retailers, but the stronger brands will survive and benefit from reduced competition during the recovery.

Retail: already in a state of flux

Long before the COVID-19 heath crisis, the UK retail market was already undergoing deep structural changes. Changing consumer behaviour and the rapid expansion of online retail were posing major challenges to retailers and owners of retail real estate. Longer term, the decline of physical retail is being overstated; but the transitional phase as the market adjusts to an omnichannel world is proving challenging to many – some of whom are not destined to survive. Capital and rental values have been falling across most retail segments and markets across the UK, with leasing and investment volumes also lower than in previous years. The current crisis could hardly have come at a worse time for the retail sector.

The immediate impacts on retailers

Evidence from previous epidemics indicates that the main economic impacts come not from the disease itself, but from the containment measures implemented by governments. Nowhere is this more true than in the retail arena; TS Lombard estimate discretionary consumer spending accounts for over a third of economic activity in the UK, so when people are forced to cut back on expenditure it hits not just retailers but the economy as a whole. As the UK government ramped up lockdown restrictions to enforce social isolation, the immediate impacts on retailers have been significant. In the run-up to restrictions being imposed, widespread stockpiling resulted in a surge in trading for grocery stores, who continue to experience levels of demand more typical of the pre-Christmas period. Electrical stores and homecrafts also benefitted from consumers gearing up for working and entertaining themselves at home. All “non-essential” shops across the UK were requested to close on 25 March, but there is no clear definition of who is allowed to remain open. Clothing and most household specialist goods retailers are closed. Pharmacies and foodstores remain open, but so do many pet shops, DIY stores and general discount retailers that include an element of food offer in their merchandising. Restrictions on movement have had an immediate impact on trading locations, with UK footfall reportedly down 80% or more year-on-year - London’s West End saw a fall of 93% according to survey company Springboard. Many retailers are shifting to “click and collect” or pure online models in an attempt to continue trading. But whilst food retailers are reporting like-for-like sales up 20% or more, most retailers are seeing a significant reduction in income through enforced store closures.

Retailers’ real estate response

The UK government readily recognised that retailers were already under pressure and need financial assistance to weather the current crisis. Many small businesses were given relief from Business Rates (the property value-based business tax) for the 2020/1 financial year, which across most of the UK was quickly extended to complete exemption for most retail and leisure businesses. Other opportunities exist to reduce rates liabilities, including for the 2019/20 period, which many retailers are exploring. Measures to support employment have also been introduced in the form of the Coronavirus Job Retention Scheme. This allows companies to “furlough” (put on temporary leave) employees until the end of May, with 80% of their salary covered by the government up to a maximum of 2,500 per month. Given the low level of wages for many employees in the retail sector, this has allowed retailers to significantly reduce their wage bills. However, the crisis hit just as retailers were preparing to pay their second quarter rent bills. In essence, retailers have fallen into one of three categories:

• those who paid the rent due, who are not necessarily the ones who are in the strongest financial position;
• those who have requested an adjustment to their rent schedule, asking to move to monthly or weekly payments;
• those who have not paid at all, or who have requested rent holidays or deferments.

Around a week after the rent was due, landlords would typically have expected to receive well over 90% of the rent owed. Evidence is mixed but across the market landlords appear to have received 50-60% of what was scheduled – although some landlords have reported lower figures. It should be remembered that these payments fell due after only a short period of impacted trading; subsequent rent collection is likely to be more significantly impacted. Retailers, along with other occupiers, have been examining leases (and their business interruption insurance) to determine whether they have any contractual basis for withholding rent payments. Whilst every situation is unique, and checking documentation carefully is essential, “force majeure” or similar business interruption clauses are not common in leases contracts (nor is the current situation typically covered by insurance policies). Tenants are exploring other avenues – such as lease rights to “quiet enjoyment” of the property, but in most cases rents remain due even if they are unable to trade from their store. Requests for some form of rent relief are therefore largely a matter of negotiation rather than right.

Landlords are businesses too …

The media are too often happy to paint a Dickensian caricature of landlords as greedy and uncaring, continuing to demand their due from struggling and downtrodden shopkeepers. The reality is somewhat different. Most retail property in major trading locations is owned by organisations that have their own liabilities, mortgages. employees, shareholders or in many cases pensioners to support. Landlords also have ongoing costs, even where units are shut down – security, maintenance and other costs continue to accrue even if a shopping centre is closed for business. Appeals to a sense of community and national spirit are laudable, but landlords are legally and morally obliged to make commercially sound judgements against a backdrop of already challenging market conditions. Some tenants have been encouraged to defer rent payments because the Coronavirus Act 2020 instituted a three-month ban on forfeiture of commercial leases for non-payment of rent, which expires on 30 June (just a few days after the next quarterly rent payment date). Landlords will ultimately have the option of reclaiming units from defaulting tenants – and technically they still have the option of suing the tenants or otherwise restraining or even initiating closure of their business, but for now they are refraining from doing so. In practice, landlord responses have been varied. All recognise that it is in everyone’s interest for tenants to remain as viable businesses, so they can resume trading – and paying rent – once current restrictions are lifted. Many landlords are therefore receptive to granting short term deferrals, with rent payments deferred for three months to be repaid over a subsequent specified period (usually 3-6 months). Some have granted complete rent holidays, often requesting an equivalent extension to the end of the lease term – albeit valuers report that the impact of such an extension is usually minimal in capital value terms. Smaller independent retailers typically receive a more sympathetic hearing, in recognition of their more fragile financial position. However, there is more resistance to rent deferral for large, well-capitalised multinationals who are often more financially secure than their landlords. Evidence thus far is that most tenants are paying their rent where they can, and that previous good relationships with landlords are bearing fruit for tenants who need to ask for support. Such conversations will become harder in the next couple of months, and landlords are well aware that a process of natural selection is underway. Retailers who were trading strongly pre-COVID will be supported and should bounce back. Those that were not will struggle to survive. More Company Voluntary Arrangements (CVAs) and pre-pack administrations are inevitable, and landlords will once again bear the brunt of these restructuring. Retailers who have already been through this process may receive less favourable treatment from sceptical property owners; having seen the business fail once, they may be tempted to extract what revenue they can while they still have the chance.

What might the future hold?

It is still too early to predict the longer-term impact of the current crisis on the retail market in any detail. The next few months at least will see materially depressed trading, with conditions taking time to return to normal even once restrictions on movement start to be lifted. Household balance sheets will be damaged, and whilst a period of “relief rally” is to be expected, spending is likely to be constrained for a significant period. COVID-19 will accelerate the demise of weaker retailers, as a combination of inappropriate corporate structures, poor trading formats and unprofitable business models are fully exposed by a decline in demand. Much will depend on the trajectory of the disease and the duration of containment measures, but an increase in retail vacancy and further downward pressure on rents appears inevitable. The shape of the recovery and the landscape thereafter is hard to discern. Some acceleration of the shift to online retail is probably likely, but this should not be overstated. Home delivery is rarely a profitable model for retailers, particularly at the budget end of the market, and cash-conscious consumers will favour value and cost over convenience. Click-and-collect will benefit, as will retailers who offer a compelling value proposition. Landlords and tenants will reflect on the experience of recent weeks and consider whether current lease terms are appropriate for the future. Some retailers are already stating they will require future leases to include a ‘corona clause’ to limit their liability for rent and service charges in the event of this type of trading disruption. Such a response is understandable, but will be a matter for further negotiation - and shifting risk towards the landlord will force costs and returns to adjust at some point in the value chain. The structural changes already underway within the retail sector will be accelerated by COVID-19, at least in part. But it would be a mistake to assume that this will be an entirely negative process – the transition may be painful, but as we have noted elsewhere, the strongest retailers will survive, benefitting from reduced competition and driving forward the next generation of physical retail destinations.