Three reasons to sell Westfield Retail

There are three reasons why we’re about to recommend you sell your holding in Westfield Retail Trust, and only one concerns valuation. Whilst it’s satisfying that the security price has risen 46% since we upgraded it to outright buy on 09 Aug 11 (Buy – $2.30), the fact is that conventional retail is a business undergoing a fundamental shift, for the worse.

Take a trip down Pitt St Mall in Sydney and you may not get that impression. Compared to three years ago, the area is transformed. Westfield Sydney glistens and gleams, bursting with new international retailers like Zara, Gucci, Prada and Gap.

These retailers pay top dollar to get prime position, so much so that according to commercial real estate specialist CBRE, of the world’s 10 most expensive cities by retail rents, Australia has three entries. Sydney in fifth place is more expensive than Tokyo; Melbourne (seventh) more costly than Zurich; and in Brisbane (ninth) you’ll pay the same per square metre in rent as you would in Moscow.

Pound of flesh

This isn’t sustainable – and that's the first reason to sell. Landlords are wringing every last cent from their tenants at a time when they’re suffering. Our concerns in this regard are well documented (see Reassessing Westfield – Part I and Part II).

Australian retail landlords are taking their pound of flesh – and bone – with Westfield the chief butcher. As Chart 1 shows, as percentage of sales, retail rents have continued to rise. Mathematically and practically, that can’t continue forever.

So what might cause rents to fall?

Which retailers will survive? Part 1 and Part 2 examined the growth of online retailing. In the past decade, online sales have grown from 2% of total retail sales to 10%, a trend that’s unlikely to abate. New retail models feature lovely websites and fewer bricks and mortar stores. There’s plenty of evidence that this is already exerting pressure on rental yields.

Mark McInnes, chief executive of Premier Investments, has threatened ‘store closures … if the rents expected by the landlords are not in line with the performance of the centre and the market generally’. Previously, McInnes achieved a 30% rent cut on Premier’s Portmans store in Belconnen, ACT. Nice work Mark.

Myer makes a similar case. According to smh.com.au, Myer ‘will close as many as a quarter of its outlets as leases expire if rental costs, estimated at 52 per cent higher than those paid on average by New York-based Saks, aren't cut.’ Rental bargaining power, once heavily weighted in favour of landlords, is swinging towards retailers.

Specialty rents falling

Westfield Retail’s recent first-quarter update admits as much. Most specialty tenants are locked in to annual rent increases of CPI plus 1-3%. This formula means, assuming occupancy remains steady (which it has), that rents should rise by around 4% per year regardless.

And yet specialty rents increased by only 2.4% in the year to 31 March. This suggests new specialty tenants are paying 5-10% less rent than incumbents. Remember that specialty retailers like Kathmandu and Howard's Storage World pay up to 10 times more rent per square metre than anchor tenants like supermarkets and department stores, and contribute far more to Westfield Retail’s profits as a result. Trends here are the ones to watch, and they don’t look good.

Westfield is alert to these concerns, repositioning its shopping centres to be fashion, food and entertainment destinations, launching an online retailing think tank and smart phone apps. But it’s unlikely to be enough.

For every Westfield Sydney in the Trust’s portfolio there are at least five others that can’t be filled with Louis Vuitton or Prada stores. There are only so many places in the country that will attract shoppers willing to pay $2,000 for a pair of shoes.

With 47 centres in Australia and New Zealand, and 15 of the top 20 centres in the country by sales revenue, the Trust can’t go around converting Westfield Mount Druitt into Westfield Bondi Junction simply to maintain rents. Upmarket shopping destinations, by definition, have to be exclusive.

As Westfield Retail has first right of refusal over the sale of the Australian assets, there’s a real risk that Westfield Group will sell its stake in some of the non-core suburban centres to the trust, making it even more exposed to the weaker part of the market.

Distributions, though, won’t fall immediately. Only around 15% of leases come up for renewal each year. Any decline will be slow, but it will be long and painful.

None of these concerns are particularly new, although the evidence of their impact is growing. The big difference is in the price Westfield Retail Trust trades at now compared to the prices we were able to recommend it previously (see Chart 2). Where once there was a margin of safety, now there is none.

Valuation gap narrows

At the time of our upgrade in August 2011, the Trust offered a 30% discount to net tangible assets and a yield of 7.2%. Chart 2 shows how the gap between security price and net tangible assets has narrowed. Now the Trust yields just 5.9%. This is the second reason to sell.

While today's yield is still better than a term deposit, with property valuations nearing record highs, unemployment still near record lows, pressure on specialty rents and interest rates knee high, this could be as good as it gets for Westfield Retail Trust.

Similar yields are on offer from BWP Trust, ALE Property Group and Sydney Airport, all of which have greater growth potential and fewer strategic threats.

Lowy family out

If you’re still doubting the rationale, let’s now introduce the third reason why we’re getting out. The Lowy family haven’t built a $30bn property empire by making dumb decisions. Recently, they sold their entire $664m stake in the Trust, despite a 10% discount to net tangible assets (NTA). Now why might they have done that?

As a passive property trust Westfield Retail doesn’t benefit from development profits from new centres, nor does it receive management income – that goes to Westfield Group. That’s why, if you have to own one of the two, Westfield Group would be our preference.

Westfield Group’s portfolio is global in nature, offers potential for more ‘destination’ style centres and gives investors a better spread of economic risk and currency exposure. Unfortunately, it yields just 4.2% (see latest review on 30 Apr 13 (Hold – $11.61)) and is nearing a downgrade.

In the end, this isn’t an 'either/or' choice. Members that have followed our recommendations on Westfield Retail Trust have done well. Even for income investors, it’s now time to bank the profits and look for other opportunities, which don’t include Westfield Group. We suggest you now SELL Westfield Retail Trust.