The fallout from COVID-19 will linger beyond lockdowns for rated retail REITs around the world. For Australian and New Zealand retail landlords, revenues plunged over the past few months as stores were shuttered and tenants were unwilling or unable to pay their scheduled rents. Meanwhile, landlords used various strategies to protect their credit quality, including equity raisings, dividend cuts, and reduced capital expenditure. Still, S&P Global Ratings expects the fallout from the pandemic to extend well beyond lower rental collections over the next few months. The structural pain will prolong as faster adoption of e-commerce and changing consumption patterns continue to buffet the sector.

Online Threat

While online shopping has been a structural threat facing Australian retail landlords for some time, it has been a slow burn. The level of e-commerce sales as a proportion of in-store retail sales remains well below markets such as China, the U.K., and the U.S. (see chart 1). However, the COVID-19 pandemic has fast tracked growth in online sales, intensifying pressure on retail landlords.

Chart 1

The fundamental question remains whether the faster adoption of online transactions is just a temporary blip, or something more permanent. Landlords are hoping for a rebound in fortunes as economies emerge from the pandemic.

We believe that much of this online shift represents a more permanent change in consumption trends, although sales will meaningfully rebound in the short-term as shopping centers emerge from lockdowns. COVID-19 has driven previously reluctant consumers online and encouraged online take-up at a much faster rate than we have witnessed in the past. For example, Australian Postal Corp. reported that 200,000 new households shopped online for the first time in April 2020. More interestingly, though, two-thirds of those 200,000 households have continued to shop online five months after their initial purchase.

Similarly, retailers have been forced to rapidly adapt or initiate online offerings in light of government restrictions. For example, hardware giant Bunnings (part of Wesfarmers Ltd.) pivoted from its traditional brick-and-mortar business model to "click and collect" during the government-enforced lockdowns.

COVID-19 has also shone a light on the retailers who were caught out because they did not have an established, user-friendly, virtual presence. Further, given many retailers were already struggling financially leading into the pandemic, the additional investment required in online capability has strained their already stretched balanced sheets. Conversely, the e-commerce shift has benefitted companies that manage their own distribution centers and were able to capitalize on the change in consumer spending patterns.

Chart 2

Rent Structures: Resisting Retailer Pressure

Retailer distress caused by the COVID-19 pandemic and online stresses have also triggered a fundamental debate between landlords and tenants around rent structures. The Australian retail REIT market has traditionally employed fixed rent lease structures with predominantly fixed and/or annual rent increases linked to the consumer price index (CPI). However, retailers argue that sales-based rent agreements should be the way of the future, because it will share the risk between retailer and landlord and put greater onus on landlords to drive customer footfall.

Our ratings assume that REITs will resist any material changes to lease structures. To date, landlords from our pool of rated REITs have held firm against any replacement of these structures.

Nonetheless, risks remain that landlords of lower-quality shopping centers could succumb to tenant demands and allow sales-based leasing deals to maintain occupancy levels. This could reverberate through the sector, triggering competition among landlords for tenants.

In our view, this change in lease structures would likely precipitate further negative property revaluations and disrupt the predictability of fixed net operating income. More fundamentally, it would likely increase the cost of capital and worsen the debt capacity and credit quality of our rated REITs.

Smaller Tenant Pool And Rising Tenant Defaults

Retailer defaults in the first nine months of 2020 rose substantially. Despite significant government stimulus and other support programs, many retailers, already under strain from online competition, were forced into administration or liquidation as shutdown measures decimated their remaining cash flows and liquidity.

Furthermore, an escalation in tenant defaults remains a material risk as government benefits and subsidies taper off and the Mandatory Code of Conduct for small and medium enterprise (SME) commercial tenancies ends in early 2021 as currently scheduled. The Code of Conduct is designed to share the burden of a subdued trading environment during the pandemic between tenants and landlords.

In our view, the ability of shopping center landlords in Australia to utilize international retailers to fill vacating space is diminishing. These tenants, including retailers such as UNIQLO, H&M, and Zara, had previously been eager to fill space, underpinning center expansions. Since the pandemic, however, Zara and H&M announced the permanent closure of a number of stores in their global store network (1,200 stores and 250 stores, respectively) as they both turn their attention to e-commerce. In October 2020, H&M launched its dedicated Australian online store and loyalty program, which offers free delivery.

Given this challenging outlook for brick-and-mortar retailing, it is unclear what the future tenant pool for shopping centers looks like and where the growth opportunities are for landlords. Landlords have been transitioning away from traditional fashion retail into an experiential, food and services offering, which has been occurring since e-commerce emerged as an effective retail distribution channel.

While we think this transition has some room to expand, it is slowly becoming more limited as the segment matures. Scentre Group, for example, already has 43% of its store portfolio designated as experience or service-based. Moreover, the space requirement for experiential and service-based tenants are generally smaller than other retail formats.

New retailers who have entered the market have also showed that you don't need a physical presence to generate sales growth and customer brand awareness. For example, The Iconic, Adore Beauty, Temple & Webster, Koala, and Kogan use their social media presence, customer following, and delivery options to let them exploit gaps in the market without a physical store.

Still, not all online pureplay retailers can weather losses for what could be an extended period of ramping up their online capabilities without an omnichannel offering. These steps include developing their distribution networks, management, and returns policies.

Limited Growth Prospects

In our opinion, growth opportunities for retail landlords will be limited over the next three to five years at least. Over recent decades, shopping center developments and expansions were justified in an environment where rents were rising year on year. Although the Australian market benefits from materially lower shopping center penetration rates (shopping center space per capita) than markets such as the U.S., we expect the economics of future investment to prove more challenging as negative rental reversion takes hold and competition intensifies.

Nevertheless, we believe that community shopping centers will continue as residential developments sprawl outside of city centers, albeit tempered by slower population growth over the next 12 months at least.

We also expect to see greater differentiation in retail asset performance. We believe that destination centers will continue to attract footfall and tenants. These centers have positioned themselves as not only a retail destination but also as a social destination driven by experiential offerings and services that are entrenched in their respective catchment areas. However, we believe that less well-positioned assets in the regional and sub-regional space are likely to bear the brunt of the fallout. Furthermore, assets in central business districts will be hit as flexible office working arrangements become the new norm.

Despite these significant online threats, however, we believe that shopping centers will remain an integral, albeit reducing, part of most retailers' strategy. While retailers are increasingly looking for a better mix of physical and online offerings, most continue to see physical stores as integral to their brand and growth strategy across a broad range of product lines. Accordingly, the main uncertainty remains the level of future demand for physical retail space relative to available supply.

The key challenge for landlords, therefore, is to understand and adapt to this changing landscape. This would include remixing their tenancies toward more experiential offerings that aren't readily substituted online, and matching supply to reducing retailer demand. Digital integration into the physical shopping experience, such as sending notifications to customers while shopping in-store could help to better merge the physical with the digital, and drive consumers back into stores. In addition, significant opportunities exist for landlords to use their centers as a last-mile delivery node for retailers given their proximity to residential populations.

For creditors, the key issue is not only whether landlords can adapt their business models to remain a central hub of community activity, but whether they can achieve this with their occupancy rates, rental levels, and fixed rent structures intact. Those most exposed are likely to be those with secondary-grade assets that are subject to strong competition and are unable to adapt their assets and tenant mix to meet this changing demand environment.