British Land - Annual Report | Property Sectoral Outlook

Business Review

Property Sectoral Outlook

Retail Sector

Leadership in Retail

£4.9 billion invested (BL share)

£8.2 billion total property under management

Following significant reshaping, the retail portfolio is now firmly focused on prime out-of-town shopping parks with Open A1 planning use, superstores and Meadowhall (our 50% share), offering the best scope for our ongoing asset management initiatives.

Our strategy for the retail portfolio is customer-led. We have built good relationships with the larger retailers and aim to continue to provide them with the right space in the locations they prefer. This is being achieved through ongoing rigorous shaping of our retail assets to take account of occupier trends and drive rental growth.

We have commented on our active management of the retail portfolio earlier in this report, aimed at delivering the best portfolio performance through high occupier contentment. Like-for-like income growth was 2.9% for the year. During the last three years we have sold £4.5 billion (gross) of retail assets, including £1.3 billion in the year to March 2009 (BL share £1.1 billion) where we anticipated weaker potential for growth in rental value or had fewer asset management prospects to enable us to create growth. We are discriminating between individual assets; for example, not all out-of-town is expected to perform well and in-town shopping centres and high streets have widely differing appeal. We expect to continue with our portfolio shaping and planning through further disposals, although probably not at the rate seen over the last few years. We will be alert to opportunities arising across the market.

Actions taken over the last three years have enabled us to weather the current market storms better than would otherwise have been the case and ahead of our competitors. Our prime portfolio now has strong defensive qualities:

high occupancy of 98%;
a long average lease length of over 15 years to first break;
low voids from tenants in administration at only 2.2% of rents (including 1.5% in negotiations or guaranteed);
27% of current retail rents from food retailers and Marks & Spencer;
valued on the basis of net equivalent yield of 7.3% (gross top-up initial yield 7.3%);
only 4% of current rents up for renewal in the next three years; and
£14 million per annum of further contracted income over the next five years.

Out-of-town - 82% of the retail portfolio, £4.0 billion:

205 retail schemes, including the Superstores and Meadowhall shopping centre;
providing a total of 22 million sq ft; and
with an average lease length to first break of over 13 years.

The retail portfolio has a particular bias to out-of-town with emphasis on retail warehousing with Open A1 (non-food) planning use, applicable to 85% of our investments in this sub-sector. Such use classification permits a wide range of retail operations and enables us to be flexible in offering asset management initiatives to deliver the size and configuration of trading space required. We also aim to be responsive to changes in those requirements as the retailers amend their formats to meet their own customers' preferences. For example, where there is retailer demand for larger or smaller units at out-of-town shopping parks, we have been active in changing unit sizes (extending or subdividing) and providing imaginative new formats, including new and varied catering outlets.

It is important to note that not all out-of-town retail parks fall into a single sub-sector. Open A1 parks are expected to outperform due to their favourable supply and demand characteristics; retailers continue to migrate to these parks from the high street, seeking and realising lower occupational costs and flexible accommodation. By contrast, bulky goods retail warehouses, which account for around 75% of the UK retail warehouses market are more restricted in their trading and retailer mix, currently experiencing difficult market conditions and have more limited prospects.

We are the largest owner of UK superstores, other than the operators themselves. The operators are gaining an increasing share of consumer expenditure through broadening product ranges, especially non food, while maintaining their customer appeal of convenience and accessibility. In an increasingly restrictive planning and regulatory environment, which is limiting new supply of these assets, the retailers are committed to full lease lengths. The Superstore investment profile of rental growth with secure income flow continues to be an attractive element of the portfolio.

During the year through the creation of a new joint venture, we sold a 50% share in the 1.5 million sq ft Meadowhall shopping centre - one of the best schemes of its kind in the UK with exceptionally strong ongoing customer appeal, and our continuing investment remains an important component of our out-of-town portfolio.

In-town - 18% of the retail portfolio, £880 million:

Six shopping centres, in total 2.5 million sq ft;
29 department stores, in total 4.6 million sq ft; and
Three high street shops.

Our in-town shopping centres are located within large catchment populations, well anchored and generally the dominant retail scheme in the area, and of sufficient size to enable proactive asset management, including new income generating customer facilities and possible future development. The department stores are fully let to Debenhams or House of Fraser with an average lease term of some 30 years. Income growth from these assets is underpinned by provisions in the leases for guaranteed increases in rent; gross rents will increase by some £5.7 million (16%) over the next five years. As part of our refinement of the portfolio, we are continuing to sell stores where appropriate.

Investment market

The investment market for retail has been adversely affected by the economic conditions. The lack of liquidity, with limited availability of debt and equity waiting on the sidelines for price levels to become compelling, resulted in low levels of investment activity for much of the year. As yields have continued to move out, the similar level of yield shift which has been applied in the market to both prime and secondary assets does not, in our view, reflect their different prospects. While we expect some further degree of outward yield movement in the market overall, this should apply less to prime where pricing should stabilise due to long and more secure income. Investors will focus on income and recognise the relative prospects for growth and the downside risks of secondary assets, such as re-letting concerns.

At current market pricing, we are now seeing the return to the market of potential investors seeking investment opportunities, primarily high net worth individuals, overseas buyers and UK pension funds, and the beginnings in some instances of competition for the right assets. While debt is still thin, it is available to purchasers with a reasonable level of equity for a sound transaction, although large lot sizes are still much more difficult to transact if debt is required.

We will be alert to acquisition opportunities and continue to be involved in the market on a selective individual asset basis.

Occupier market

Current market conditions are challenging; while total retail sales seem to be holding up better than most had feared, in a competitive trading environment like-for-like sales for most retailers are down and continue under pressure. There continues to be real possibility of rental value declines particularly where voids, lease expiries and corporate failures are creating a demand/supply imbalance and pushing down rents. Much will depend on the impact on consumers from wider economic outcomes. Home related (DIY, furniture and carpets) and electrical goods retailers are bearing the brunt of the downturn in consumer confidence, which will adversely affect the bulky goods parks. Clothing sales are mixed, entertainment is faring better and food is trading more strongly. As a result, demand for new stores is thin as retailers preserve their positions.

Our occupier led strategy has been based on owning retail property in locations where our customers trade profitably and our portfolio is positioned accordingly. Prime retail, while not immune from ongoing market uncertainties, is better placed, with stronger occupational demand, better retailer trading and tenant covenants, higher occupancy and longer leases.

Office Sector

Leadership in London Offices

£3.6 billion invested

We have continued to manage the office portfolio by taking opportunities to sell a total of £1.8 billion (gross) of offices over the last three years to take advantage of higher market prices, having recognised that London offices had been in a cyclical upswing. These sales were primarily in the City (78%).

Our strategy for the offices portfolio is to concentrate on prime assets in the City and West End of London. Despite recent credit market turbulence, London's global position as a business centre is well established and we consider London is the right place to be over the medium term.

Our customer focus is on providing modern, high quality and well located accommodation to meet the requirements of the financial and business services based in the capital. We build on this by offering 'best in class' property management, from estate services through to development of new buildings. Proactive asset management aims to tailor what we offer to customers' changing needs.

We have a relatively well positioned prime London office portfolio with strong income:

4.4 million sq ft in the City;
1.4 million sq ft in the West End;
investments over 94% occupied;
93% of vacant accommodation is brand new Grade A;
weighted average lease length of over nine years to first break (11 years to expiry);
valued on the basis of a net equivalent yield of 7.2%
(gross top-up initial yield of 7.8%);
only 9% of current rents up for renewal over the next three years;
£23 million per annum further contracted income over the next five years; and
an average rent of £46 per sq ft.

Our continued active management of the office portfolio is set out in detail earlier in this report. The £616 million of sales in this year, achieved in a difficult market with falling values and limited liquidity, have been overall accretive to our performance for the year. New income has been generated of £2.5 million per annum from settlement of rent reviews and of £13.7 million per annum from new lettings, including 300,000 sq ft at our London developments, with more under offer. The completed developments at 201 Bishopsgate and the Broadgate Tower continue to attract new tenants: including areas currently under offer, the Tower is 64% let and we have only 12% of 201 Bishopsgate remaining available. On the investment portfolio, like for like income growth of 2.5% for our offices has been achieved over this year - 1.3% in the City and 7.6% in the West End.

Completion of these development projects and deferral of Leadenhall has reduced our committed office schemes from 2 million sq ft last year to less than 1 million sq ft, now representing less than 4% of the total portfolio value. Included in this is Ropemaker where we are pleased to have reached agreement with The Bank of Tokyo-Mitsubishi UFJ, Ltd and Mitsubishi UFJ Securities International plc for a major pre-let of 186,500 sq ft. Tenant interest is also being seen in the Regent's Place office development, although large pre-lets in the West End are relatively unusual and we have always believed that significant progress in lettings will be achieved after the buildings are completed and available to view. The residential units at Osnaburgh Street (part of Regent's Place) have all contracted for sale, de-risking the project, with completion due later this year.

Investment market

The London office market, along with all other sectors, has been affected by the financial markets and economic conditions. Given the lower levels of debt available and the uncertain investment climate, a significant downturn in transaction volumes has been seen this year. However, during our financial year some £3.5 billion of London office property has been traded, indicating that there continues to be a degree of liquidity from equity investors even in this difficult market - and the level of sales we have achieved from our portfolio at over £600 million is a good result.

The reduced relative liquidity has resulted in significant adjustment of yields since mid 2007, with the City having moved out by 320bps (with prime now at 7.2%) and the West End by 270bps (prime 6.0%). In a low interest rate environment, these current yields are starting to look attractive to income-hungry funds and there are now early signs of investor demand returning to London. The relative devaluation of Sterling is also attracting growing interest from overseas purchasers, notably the German funds. These factors together are generating more positive sentiment and there are early indications that yields on prime, well let buildings have started to stabilise.

Secondary assets, which lack occupier appeal and security of income (and have little prospect of raising new transaction debt) remain most vulnerable to further falls in value. At this stage it seems that the banks are unwilling to call in loans which are under pressure, so there is very little evidence of an impending wave of 'distressed' sales coming to the market. Nevertheless, the gap between prime and secondary yields is likely to continue to grow.

Occupier market

London offices continue to have relatively low vacancy rates, although the current level of 7.3% (being below the long term 20 year average of 8.1%) is expected to rise, due to completion of development projects in progress without pre-lets, together with the release of tenant controlled accommodation. Many forecasters currently believe the vacancy rate in London will rise no higher than that seen in previous downturns, primarily since the total level of new development has not been as high in comparison to earlier office cycles.

The most important factor in the current significant slowdown in take up is that business confidence has been severely dented and demand weakened. Even occupiers who have requirements are reluctant to make decisions on their accommodation in these uncertain times. We are aware that many businesses would like to improve, consolidate or expand their offices but are reluctant to commit at this stage. Financial and business services are unlikely to generate employment growth this year. It will require a return of confidence in the economic outlook to restore take up and release a degree of pent up demand in the occupational market.

British Land's office portfolio is modern, high quality, well located and let with good income security. Our development exposure is limited and the committed projects, spread between the City and the West End, will produce prime offices attractive to new occupiers.