by Martin Meech
At a time when most occupiers of commercial property are wading through a blue haze of Inland Revenue forms it is perhaps appropriate to consider some effects of this revaluation exercise.
The long-awaited rating revaluation in England and Wales takes effect from April 1 1990, together with the implementation of the national non-domestic rate (NNDR). It is the combined effect of these two measures that is of interest to the occupier of commercial property. The general consensus in the industry is that the retail sector will bear the greatest impact of the subsequent shift in rate burden. For most firms in the sector this is perhaps not such a great revelation, considering that retail has produced a greater rental growth than any other sector in the 17 years that have passed since the last revaluation.
Many analysts have attempted to quantify the combined effect of revaluation and NNDR, although all such attempts are by their very nature hypothetical, especially in view of the fact that the effect will vary geographically and that the rate of NNDR has not been fixed.
It is useful, however, to use the British Retailers Association’s estimate of an increase of 60% as a guide for a portfolio of major national multiples having an even geographical spread of stores in the High Street. The retailer predominantly located in out-of-town retail sheds is probably looking at an increase rate burden of 70% to 80%. A retailer such as my own company, Halfords, having a spread of retail units from secondary to prime High Street locations and prime out-of-town units, is looking at an increased rate burden of about 40% to 50%. The retailer with a prime High Street portfolio located predominantly in the South East will suffer the greatest increase, with some individual properties producing an increase of over 200% in rate burden.
These increases are clearly significant, hence the pressure from retailers to phase in the heavier rate burden. The lack of certainty with regard to quantifying the rate burden and its phasing, together with the consequential effect on the quality of investment decisions, is perhaps of even greater significance. The effect the rating revaluation will have in the retail market is, therefore, difficult to predict, but I would like to indicate several probable scenarios by looking first at the demand for retail space and, second at the supply of space.
The effect on the demand for existing and new space by retailers will depend on their ability to pass on to customers the increased cost of rates or to cut other operating costs. The specialist retailer offering a quality service will inevitably find it easier to improve margins than, say, the discount or general store retailer. Consequently, the growth of the specialist retailer will probably be enhanced, with existing large space users giving up space to specialists.
In the High Street, it is interesting to note the indication given by the Lewis department store group to release space for standard specialist shop units. In the retail warehouse market the average size of a DIY unit or furniture store is now about 35,000 sq ft. Existing units of 60,000 sq ft or more where product ranges have been extended to include goods with lower margins and stock turns will increasingly become more profit marginal. Retailers may well find it more beneficial in such cases to sublet space after 1990 to other retailers specialising in, say, tiles, glass products, electrical goods or road-user products, who can justify higher product margins and, therefore, higher property costs.
To an increasing degree retail parks will become a collection of specialist users — DIY, furniture, carpet, electrical and auto accessories, for example. Indeed, this would mirror the historic development of the High Street from the former general store to the present-day predominance of the specialist in line with dramatically increased property costs.
Another way in which the demand by retailers will be affected is that space will be used more intensively, particularly in out-of-town retail warehouses. Increasingly, free-standing mezzanine floors have been introduced in recent retail warehouse developments, initially as a means of increasing storage space and now for use as retail space. I predict that this trend will increase as 1990 draws nearer. I would also predict renewed pressure from retailers not permitted to trade on Sundays for a change in the current legislation, along with an extension of opening hours generally, as a means of overcoming some of the effects of the revaluation.
It has always seemed illogical to me that town centres, with a captive consumer — the office worker — during the week, should close their shops at 5 pm just at the time that the workers emerge to spend their earnings. Late-night shopping is popular with the customer, and should be given a boost following revaluation.
Inevitably the recent growth in consumer expenditure has permitted the existence in retail markets of inefficient operators, who have generated profits merely through the growth of the market. The substantial increase in the rate burden after 1990 will inevitably put such retailers under pressure and will test their ability to manage a long-term retail business. Some will fall at this first hurdle. The strong, efficient retailer will no doubt fill the gap left, to the benefit of the customer, as the survivors will succeed through greater efficiency, improved-quality service and customer choice through specialisation.
The effect on the supply of retail space will be determined by the institutional investors’ opinion as to the retailers’ demand for space and, consequently, the ability to maintain rental growth. At present there is an excess demand for retail space both in the High Street and out of town. It has recently been estimated that the demand for retail warehouse space is currently at 13m sq ft pa against a current opening rate of 7m sq ft pa. This has manifested itself by the growth in rental plus premium bids for such space. I would, therefore, suggest that the downward pressure on yields will continue, together with good rental growth.
I would, however, suggest that the existing level of excess demand will decline but not disappear as retailers reduce space requirements and the inefficient leave the market. This will manifest itself in a fall in the level of developers’ premiums as opposed to any detrimental effect on the investment market.
Some analysts have suggested that retailers will claw back some of the increase rate burden from landlords in terms of lower settlements at rent reviews. As a retailer, I wish I could share their optimism. Their view, I believe, would hold true only if the rate of supply of retail space was exceeding the growth of retail expenditure. Unfortunately, in overall terms supply is increasing at around 1.5% pa and consumer expenditure at 4%. Consequently, it will be the demand for space that will create rental evidence, as opposed to rent review settlements creating the tone of market values. Needless to say, these are existing overall figures, and particular locations will vary from the average: any continued increase in mortgage rates, again, will affect future consumer expenditure, particularly in certain retail sectors.
One important effect the rating revaluation will have on the supply side is that investors will become more critical as to the quality of tenants, the quality of tenant mix in developments, and the quantity-split of space between tenants.
Increasingly, institutional investors/developers will limit the amount of space taken by one retailer, particularly if it is at the expense of another specialist. This trend is beginning to show itself by the increasing resistance of investors to allow sublets on the grant of leases in new developments, thus encouraging tenants not to take marginal space which may prove to be surplus at a later date. I would also suspect that in the out-of-town retail shed market, the smaller retail park of about 100,000 sq ft will become increasingly popular, as by its nature it restricts the space let to individual retailers and attracts the specialists.
In conclusion, I would acknowledge that the repercussions of the rating revaluation will have varying effects according to particular regions, towns and sectors of the retail market but, overall, I believe it will not seriously affect the demand or supply for retail space. Indeed, I believe although it may be the last “nail in the coffin” for the inefficient retailer, the strong efficient retailer should only become stronger, particularly the specialist who is also a national multiple. This is a comforting thought, no doubt, for the retailer, retail developer and property investor.
Ultimately, any pressure for greater efficiency and quality brought about by the revaluation will benefit the customer.
I would, however, conclude on one note of concern: to avoid the effects of the rating revaluation becoming a “revolution” the market must be allowed to evolve and cope with the dramatic shift in the rate burden, and this can be achieved only through the phasing of the change.