Shaken or Broken: are the retail market’s perceptions of covenant strength shifting?

Company Voluntary Agreements, retailers collapsing into administration and rent arrears are circumstances that have become commonplace in the retail market but have been making landlords nervous about the security of their income streams. Large landowners, even those with capital buffers to help them over the lean periods, are uncomfortable with these risks and subsequently those with a lower tolerance to risk have already left the retail investment market. For the smaller scale property owners stuck holding High Street assets, this has been an extremely difficult time as they often depend on the rental income they collect to repay their own business loans and in some instances is their main source of personal income. For these property investors, tenant credit worthiness and default risk are important issues.

Significance of Covenant Strength

Credit worthiness underpins the confidence a landlord places on the ability of a tenant to pay their rent, which is ultimately a financial obligation. The strength of a tenant’s financial position, their credit worthiness, is what the property market means by covenant strength and represents the likelihood a tenant will default on paying their rent.

This is a serious consideration for property owners as it not only influences the income they collect, but moreover impacts on the market value of a retail asset through the capitalisation rate (investment yield) used by a valuer in their valuation, which encapsulates the market’s perception of the default and income void risks attached to the property and its occupier. The stronger the financial position of a tenant, the stronger the covenant strength and lower the yield (assuming all other factors are held constant) which pushes up the market value of a property.

Hence, the greater the confidence investors have in the sitting, and future potential, tenant to continue to pay their rent then the more they will pay to buy this asset, which is effectively a legal right to collect future rental incomes. Subsequently, landlords in the past tended to prefer letting their property to occupiers perceived to have a strong covenant, typically big brand multiple retailers and often ‘blue chip’ companies. Credit check ratings, such as Dun & Bradstreet and Experian, were often used to screen out tenants with weaker covenants along with deposits often being demanded as security and parent companies were required to guarantee the rent liabilities of financially weaker sub-companies.

Changing perceptions

Let’s be clear, landlords will always prefer a stronger to a weaker covenant, for the very reasons outlined above, but the research of REPAIR Team, through interviewing landlords and agents, has discovered a change in covenant strength perceptions. Retailers, traditionally taken for granted by landlord as strong covenants, are included in the ‘mounting pile’ of occupiers that have collapsed or entered CVAs in the last five years. The speed of some financial positions unravelling in the market, Patisserie Valerie for example, being particularly unnerving. Confidence in guarantors has also been knocked as sub-companies being sold on to different owners with completely different debt structures and financial strength seems to be occurring more frequently, and shorter leases with 2- or 3-yearly tenant-led breaks have increased the risk of voids regardless of the tenant’s covenant strength. These adaptations have taken the market to the point where agents and investors are now asking “what is covenant?”

There have also been changes in covenants previously perceived as weak. Take, for instance, discount or value retailers. Some of them are now regarded as ‘good tenants’ and appearing in the more desirable locations in towns and cities, an example being Poundland that popped up on Princes Street, the primary retail frontages traditionally regarded as the prime pitch in Edinburgh, although other findings by the REPAIR Team show that this pitch has moved eastwards over the last 10 years.

Another change is that some landlords are being more open minded about independents and small local multiple tenants. As national and international multiples are letting fewer vacant shops, some landlords realise that independents, committed to a specific location and keen to make their business work, can be reliable tenants. If business minded with a good business concept, then these tenants carry acceptable default risks, a shift in perception which partly explains the growing number on the High Street.  Perhaps this is only a temporary change in their position because landlords have no other option given the absence of large chain retailers looking for new space but the current situation is helping to break down some of the historic perceptions and biases that existed in the market. One thing is for sure, more independents and a greater variety of operators contribute to the much needed diversity on the high street. Thereby, these changes should help with the reinvigoration of local economies and build resilience in our retailing centres.

– Allison Orr

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