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UK retail landlords told to prepare for troubled tenants

Struggling high-street retailers in the U.K. will likely need to renegotiate lease terms with landlords in the coming year as profits are attacked from a number of angles.

Costs for U.K. retailers are expected to rise throughout 2017 as the depreciation of sterling — brought on by the country's vote in June 2016 to leave the European Union — makes imports more expensive. Meanwhile, the long-term growth of e-commerce, the introduction of higher business rates — government taxes placed on most non-domestic properties — in April and the escalating national living wage are also expected to hit revenues and push up costs.

"This year is going to be the toughest year the retail industry has ever seen by some distance," Richard Hyman, a retail consultant who advises several of the U.K.'s major high-street outlets, said in an interview with S&P Global Market Intelligence. "Gross margins for the retailer are under pressure like we've never ever seen, and I think that their ability to pay rents at current levels has diminished materially. There has to be a rethink," he added.

Tough trading conditions in 2016 saw many traditional store-front retailers in the U.K. take measures to reduce costs as competitors went out of business. U.K. retailers slashed around 84,000 jobs in the sector in the final quarter of 2016, a 3% reduction in the sector's workforce from the same period the year before, figures released Jan. 25 by the British Retail Consortium revealed. According to a report by accountancy firm PwC and the Local Data Company, there were 15 shop closures a day across the U.K. in the first half of 2016, a period during which department store chain BHS fell into administration, leading to the closure of over 100 branches.

The deteriorating operating climate is expected to see similarly large U.K. chain stores struggle to maintain margins. Next, the U.K.'s 15th-largest retailer by sales in the 2014-2015 financial year, according to RetailWeek, warned Jan. 4 that its profits could fall by as much as 14% in 2017, with consumers facing price increases of up to 5% due to the depreciation of sterling. The U.K.'s currency is down around 15% against the dollar and 10% against the euro since the Brexit referendum, with inflation hitting a two-year high of 1.6% in December. U.K. retail sales in December fell at the fastest month-on-month rate in nearly five years, down 1.9% from November, the Office for National Statistics said.

"I've been a structural bear on the [retail] sector for quite a long time," Robert Duncan, director of research at Numis Securities, said in an interview. "Brexit for me is not another catalyst for underperformance because [the retail sector] was already going to underperform. But it has made what is a challenging sector even more challenging."

Retailers also face the impact of a rise in the U.K.'s national living wage in April to £7.50 from £7.20 per hour. This will be compounded in the same month by an increase in business rates for many high-street retailers, with businesses in London particularly affected. Rates for traders in some of the U.K.'s provincial cities will remain unchanged or even decrease, however.

Despite the increasing difficulties faced by store-retailers, prime retail rents in the U.K. have either remained stable or seen high growth in the last five years. Six major U.K. cities beyond London saw growth of between negative 0.4% and 3.3% from September 2011 through to September 2016, according to a retail market snapshot by Cushman & Wakefield. In that same period, London's West End saw retail rents grow by 17.9%, while the rest of the city experienced a 5.8% increase.

Such hikes by retail landlords are piling further pressure onto tenants, putting the landlords' own businesses at risk in the long term, said Hyman. "I think that U.K. retailers' capacity to pay what they've been paying is over," he said. "I think that everyone needs to step back and revisit their economic models because the one thing I'm certain of is that the way things have been in the past is no longer workable. It's no longer economically viable going forward."

U.K. retail landlords are also contributing to their tenants' problems by failing to invest sufficiently in their secondary and tertiary mall and shopping center assets, Duncan said, many of which have seen the greatest decline in physical sales. "They need to stop spending on developments and extensions, and they need to spend that money on their existing portfolios to bring them up to scratch," he said.

U.K. high-street retailers have been facing a particularly strong challenge from online traders such as Amazon.com Inc. and Alibaba Group Holding Ltd. compared to other European markets. Online sales made up 15.2% of total retail trade in the U.K. in 2015, according to the Centre for Retail Research, compared to 11.6% in Germany, which was the second-biggest European market for online sales. The 2015 U.K. figure was up from 13.5% the year before, and is expected to have risen to 16.8% in 2016.

The evolution of consumer habits is leading to a period of "structural change" for the U.K. retail market, Jonathan Rumsey, U.K. head of retail research and insight at Cushman & Wakefield, said in an interview, with space in certain towns and cities needing to be "repurposed to different use-classes such as residential."

However, the opening of physical stores by online retailers such as Missguided proves that traditional retail outlets still have a role in the sector, he said. "I think retailers have come to terms with the convergence of offline and online, so it's not just going online, the physical store is still very important in a retailer's network."