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Retail store development at the margin
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U T T E R W O R T H E I N E M A N
Journal of Retailing and Consumer Services Vol 2, No 1, pp. 25-32, 1995 Copyright © 1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0969-6989/95 $10.00 + .00
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0969-6989(95)00030-5
Retail store development at the margin Clifford Guy Department of City and Regional Planning, University of Wales College of Cardiff: PO Box 906, Cardiff CFI 3YN, Wales, UK This paper explores some outcomes of current financial and market pressures on grocery superstore developers in the UK. Relationships between the size of a store, its net profit margin, and the land costs involved are examined through simplified methods of investment appraisal. It is shown that increased levels of competition, from both superstores and discount grocery stores, are likely to drive down bids for land from the very high levels seen at the end of the 1980s. Empirical investigation suggests that this process is already occurring. Practical and theoretical implications of these findings are discussed. K e y w o r d s : g r o c e r y stores, s u p e r s t o r e s , land costs
The development programmes of large grocery stores in the UK have stimulated research among retail analysts, geographers and town planners for many years. Between 1967 and the beginning of 1993, some 776 'true" grocery superstores of at least 2500 m 2 sales area were opened, and a further 101 had received planning permission (URPI, 1993). At least 100 slightly smaller stores showing similar characteristics also exist. This scale of development has encouraged spatial analysts to map the diffusion of large stores across the UK, and the changing competitive structure of mass market grocery retailing (eg Jones, 1981; Davies and Sparks, 1989; Thorpe, 1991; Wrigley, 1993). A second major research focus has been on the economic impact of large new stores upon smaller stores and traditional shopping centres, and the implications for town planners (eg Gayler, 1984; Guy, 1987; BDP Planning, 1992). One of the key issues here has been the availability of land for new store development. Most of the debate has focused on the restrictions on land availability that result from town planning policy. However, a related but much less studied issue lies in the distortions to the land market itself that have resulted from the ambitious development programmes of the major superstore operators. Extreme competition for good-quality sites with planning permission has resulted in hoarding of land and inflated prices. This in turn has reduced the profitability of new store development and has led to criticism of the grocery multiples by institutional investors.
This paper examines in particular the land market for superstore development and ways in which land prices affect, or are affected by, the viability of new store development. As there seems to be little existing academic work on this topic, the examination is exploratory and there is little discussion of empirical evidence. The analysis of store development and land costs relies on methods of appraisal routinely used in both property development and financial forecasting. The paper demonstrates that land costs, a topic largely ignored in the literature on store location, are important in their own right and can be both cause and effect of changes in store development programmes. Recent changes in grocery store development in the U K The late 1980s appear in retrospect to have been the 'golden age' of grocery store development in Britain (Wrigley, 1991, 1994). Rates of superstore development increased as it became clear how popular such stores were with shoppers. An increasingly liberal town planning regime made off-centre sites easier to obtain. At the same time several large companies moved up market and emphasized variety and quality of grocery products rather than price. This enabled operating margins to increase from around 3-5% in the mid 1980s to around 6-8% in 1992 (Henderson Crosthwaite, 1992). These margins are much higher than in the rest of western Europe or in North America, where 1-2% is more common. 25
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Towards the end of the 1980s, major structural changes occurred in British grocery retailing. Two major companies, Asda and Gateway, were for financial reasons forced to call a virtual halt to their superstore development programmes. Superstore development thus became concentrated mainly within just three companies: Tesco, Sainsbury and Safeway (part of the Argyll Group). The profitability of superstore development encouraged these retailers to accelerate their store development programmes. Extra finance was raised through rights issues and sale-and-leaseback arrangements (Wrigley, 1991; Guy, 1994a). Until very recently, each company intended to open at least 25 new large stores every year for the foreseeable future, stating that literally hundreds of new sites were being seriously considered (Guy, 1994b). These plans have been thrown into doubt by an increasing realization that market saturation has arrived or is imminent in many parts of the UK. Although this was much anticipated in the analytical literature (eg Treadgold and Reynolds, 1989; Duke, 1991; Guy, 1994a, 1994b), it was only around the beginning of 1994 that the Big Three themselves appeared to recognize that their expansion could not be maintained indefinitely. Stores were already being developed in areas where previously the catchment population had been perceived as too small to warrant a large grocery store. It appears now that development programmes are to be cut back to around 20 stores per annum. These will include stores smaller than the conventional superstore in market towns, plus a few much smaller town centre stores, which will be targeted at the town centre employee for convenience food purchases (Clarke et al, 1994). A further major issue has been the rise of the 'discount' store in the UK (Gascoigne, 1992; Wrigley, 1993; Burt and Sparks, 1994). At the end of the 1980s several western European retailers became interested in the UK market. They perceived a new opportunity to sell limited ranges of goods to price-conscious shoppers. Prices were kept low by accepting low margins; by developing cheap 'no-frills' stores in cheap locations; and by selling own-brand or 'tertiary brand' goods, which did not carry the promotion and marketing overheads of the top branded goods. These retailers were thus able to undercut the Big Three's superstore prices substantially. The leading British discounter, Kwik Save, responded to these new threats by expanding its store development programme and by attempting to compete where necessary on price terms with the new 'European' discounters, Aldi and Netto.
Pressures on the superstore developers In contrast with their counterparts in several other European countries, the major grocery retailers in 26
Table 1 Grocery company share values, 1993-94 Company
Share price 8 April 1994
1993 Highest share price
1994 Lowest share price
Sainsbury Tesco Argyll Group Asda Group
362 212 250 57
480 254 306 66
342 210 240 55
Source: Sunday Times, 10 April 1994
the UK are mostly public limited companies, whose performance is subject to constant scrutiny by institutional investors and City analysts. This helps to provide a rich source of up-to-date information and expert opinion, some of which is discussed later in this paper. It also puts the major companies under considerable pressure to maximize short-term as well as long-term returns on investment (Myers, 1992). What may appear to the outside observer as minor fluctuations in performance or threats for the future can have a major effect upon share prices. At the time of writing, share prices for the Big Three and Asda are very low by recent standards (Table 1). The reasons for this are briefly as follows. First, there is the concern over market saturation. Rising sales and profits have been based upon the expansion of floor area through the store development programme. Year-on-year increases in sales and profits through existing stores have in recent years been very modest and, in the case of Sainsbury and Safeway in 1992-93, appear to have actually been below the rate of food price inflation (EIU, 1993a). Growth in sales is thus created very largely by new store development. Any reduction in store development programmes - or a switch to development of smaller stores - suggests slower future increases in sales. Furthermore, recently opened stores appear to record lower sales per square metre than stores opened in previous years (Henderson Crosthwaite, 1992). Second, there is the impact of the discounters. The extent and nature of this impact are not yet clear. Recent research suggests that discounters are more likely to compete with each other than with the superstore retailers (Hogarth-Scott and Rice, 1994; Schmidt et al, 1994). However, evidence from the Manchester and Cardiff areas suggests a consistent switch in custom from the Big Three to Kwik Save and other discounters in the last three years (Clarke et al, 1994). Certainly the City has been concerned over this issue. The Big Three have in various ways made some gestures towards reducing prices. This may help to retain or attract custom but it is likely to lower the companies' operating margins. Third, the Big Three companies and (at one time) Asda have been criticized for paying high prices for the land required for new store development. Sainsbury and Tesco are seen as the major culprits. This issue is discussed in the next section.
Retail store development at the margin
Fourth, certain accounting devices used by the major retailers have been roundly criticized by City commentators and have been adjusted recently to meet these criticisms. This has reduced the apparent profitability of the companies. The much-criticized device of capitalization of interest paid on loans to finance store development has been discussed by Credit Lyonnais Laing (1991) and Wrigley (1992), and need not concern us here. Conventions in the valuation of property holdings have also been under discussion and these are relevant to the arguments presented later in this paper. Briefly, the question is whether the companies' land holdings, especially those on which superstores have been built, should continue to be valued at cost price plus monetary inflation, or should be assumed to depreciate over time. The latter is normal practice in company accounting. The question is particularly important for superstore retailers because there is clear evidence, discussed below, that the retailers have paid much more for land in recent years than other land users would have done. The first major grocery company to accept City criticism and allow depreciation on property holdings was Wm Morrison in 1992. The other major companies have now followed suit, despite the reduction in their apparent assets that results from this decision (Credit Lyonnais Laing, 1992a, 1992b). In addition, they have made one-off writedowns in the value of their property to acknowledge previous overpayment for sites. For example, in the financial year 1993-94 Sainsbury wrote down £341.5 million of property values, of which £282.4 million was in respect of the 'value of land element of trading properties" ISainsbury, 1994, p 51).
located outer suburban sites with appropriate planning permission in south Wales in early 1994. During the late 1980s the prices paid by grocery companies rose rapidly as competition became more intense. Certain 'totem sites' in the south-east of England were purchased for between £2 and £3 million per acre by Sainsbury, Tesco and Asda (Kleinwort Benson, 1991). At this time the difference between superstore site values and other retail was substantially higher than that shown in Table 2. For example, prices for retail warehouse sites were typically no more than £500 000 per acre or perhaps at maximum £1 million per acre in southeast England. Typical superstore land prices continued to rise between 1989 and 1991, when the remainder of the property market was in serious slump condition (Credit Lyonnais, 1992a). More recently, superstore site prices appear to have fallen, to typically between about £300 000 and £1.25 million per acre, but they are still above typical retail warehouse site prices. There is great variation in superstore land prices, which reflects not only the quality of the site but local property conditions generally plus a substantial 'chance' element. The highest prices appear to occur when more than one operator is interested and a competitive bidding process ensues. It is sometimes necessary to add to these very high prices further costs related to planning gain extracted by local authorities in return for allowing planning permission (Guy, 1994a). The cost of land is not only a major part of total development costs, as shown in the next section: it also ties up the company's capital during an unproductive period while the site remains in the company's "land bank'.
Superstore land costs
Land costs and the investment decision Any company wishing to carry out property development should carry out some form of investment appraisal. Typical methods are described in Baum and Crosby (1988), Brown (1991), Dubben and Sayce (1991), Hargitay and Yu (1993), and Fraser (1984). The intention should be to achieve some suitable rate of financial return from the investment, over a period of years. The four components in the appraisal are:
It is well known that the price of an area of land can vary according to the existing or proposed use of that area. Many writers, including Alonso (1964), have shown that commercial users value accessibility particularly highly, and are likely thus to 'capture' the most accessible areas in an urban system through the competitive bidding process. It may not be as obvious that different commercial or even different retail users will be willing to pay significantly different amounts for the same land. This competitive bidding takes place in outer suburban locations rather than the central city areas emphasized by Alonso. Table 2 shows typical prices paid for well-
(1)
(2) Table 2 Typical land values in South Wales Type of land use
Value (£'000 per acre)
Agricultural Residential Retail warehouse park Grocery superstore
1 200 300 500-1000
(3) (4)
the capital value of the site at the beginning of the period, CV, ~, which can for the owner-occupier be equated with initial development costs, including site costs and construction costs: the capital value of the developed site at the end of the period, CV; the net cash flow derived each year (i) from the completed development, C/; the internal rate of return (IRR) to be derived from the investment, usually expressed as an annual percentage of the initial development costs, r. 27
C Guy
These components are related to one another in the equation
CV,_,
-
C V~ Ci + ~_~ (l+r)" i=l ( l + r ) i
(1)
where n is the total period in years (Hargitay and Yu, 1993, p 207). The first term on the right-hand side of the equation represents the discounted value of the capital value at the end of the period, and the second term represents the sum of discounted cash flows (DCFs) throughout the period. This type of analysis can be used in two ways. First, an internal rate of return can be assumed in advance, typically in property transactions at the current rate of return available in Government giltedged securities, plus a premium of at least 2% to cover the risk associated with property investment (Dubben and Sayce, 1991). The equation is then used to determine the capital value that will just provide that IRR. From this value, construction and other costs are deducted to produce a residual estimate of land costs. The developer will then be willing to bid up to this amount when attempting to buy the land. A second use of this equation is to calculate the I R R that would result from a given initial expenditure, CV,_~. Frequently the developer is offered a site at a fixed price, and it is necessary to find out whether an adequate rate of return is likely to result. Clearly, r cannot be calculated directly from Equation (1), but valuation tables can be used to provide an approximate estimate of r. These methods are normally used in appraising speculative property developments, such as office blocks or regional shopping centres, in which the income will be derived from rents paid by future tenants. It should also be expected that the capital value of the scheme at the end of the period is as much as or greater than the initial capital value. In appraising any retail scheme in which the developer is also destined to be the retailer, there are two major differences from conventional property schemes. First, incomes are derived directly from retail sales, converted into profit through application of a gross margin on sales. The gross margin is to some extent a strategic choice of the retailer, but sales depend upon the size and characteristics of the store's catchment area. Second, the final capital value of the site (including the store itself) is unlikely to be as much as the initial development cost (Credit Lyonnais, 1992a). This is partly because the store itself will to some extent become obsolete, and partly because the company may have paid a premium over normal retail land prices in the first instance (see above). This has been reflected in recent decisions of the Big Three to depreciate their land holdings, although the rate of deprecia28
tion (2% pa for Sainsbury, and 2E% for Tesco) has been criticized as being too low (Strauss Turnbull, 1994). Naturally, the major retailers do not seek to publicize their own investment appraisal methods. However, it is known that each proposed new superstore is subject to an appraisal in its own right. Typically the retailer will estimate potential sales at the site, using a gravity model (Penny and Broom, 1988) or some other method, and then estimate how much it can afford to pay for the land: Supermarket operators evaluate each individual site by attempting to predict the turnover that would be achieved if they were to build there. The turnover will determine the amount that can be paid for the land.' (Sainsbury, nd) City analysts such as Kleinwort Benson (1991) and Credit Lyonnais (1992a) have attempted to replicate this type of appraisal in order to judge the prospects for profit growth among the retailers. Their models, which are stated to be similar to those used by the major companies, rely on year-by-year projections of sales and costs in a typical superstore. Some sensitivity analyses derived from these models are discussed in the following section. Two general modifications of the basic appraisal model (Equation (1)) can be derived from their analyses. First, initial capital value is composed of land cost plus construction cost: CV, i = L C + C C
(2)
Second, net cash flow per annum is composed of sales mediated through the gross margin (expressed as a proportion of sales), less labour costs and operating costs: Ci = S i G M i - L C i - O C i
(3)
where G M i is the gross margin for year ii, expressed as a proportion of sales rather than the usual percentage value. It is clear from this discussion that sales, gross margin and land costs are all vital ingredients in determining the viability of a superstore. The latter two are often neglected in the literature on store location, which emphasizes sales forecasting as a major input to the store location decision (eg Ghosh and McLafferty, 1987; Wrigley, 1988). Simulation of the investment decision
Kleinwort Benson (1991, p 30) examined the maximum land cost that a major retailer might reasonably pay for a site sufficient to develop a store of 66 000 ft 2 gross retail area. Using information on typical ratios of sales per square foot, and typical values of gross margin and of other cost factors, the following land costs would just allow an 'acceptable' DCF return of 10% (adjusted for tax and inflation):
Retail store development at the margin Tesco Sainsbury Argyll Asda
£22.5 £19.8 £15.5 £10.6
million million million million
The site required would be about 8 acres, to include some 600-700 car parking spaces, petrol filling station, etc. This indicates that the costs of £2-3 million per acre being paid in exceptional cases at that time would still just about have allowed a viable development for Sainsbury and Tesco. The difference between the four companies' ability to pay land costs lay partly in their different ratios of sales per square foot, but also in different ratios of sales area to gross area: Tesco was at that time able to 'squeeze' more sales area out of a given size of building. Since 1991 several elements have changed. While labour and operating costs have risen slightly, the important change that has led the commentators to revise such estimates has been the reduced amount of sales projected for a typical new store, given that the companies are now developing poorer sites as saturation looms. In addition, the impact of the discounters means that gross margins are likely to be reduced from the very high levels of the early 1990s. G o v e r n m e n t statistics show that gross margins of large grocery retailers rose from 18.0% of tax-exclusive turnover in 1980 to 24.2% in 1991 (Central Statistical Office, 1994, Table 3). More recent data are not available, but Tesco have revealed that their gross margin fell by 0.4% in 1993-94 (Tesco, 1994, p 16). Thus the growth in margins characteristic of the 1980s may now be reversed because of the need for multiples to introduce more price-cutting lines (see also EIU, 1993b, p.79). A third change in the analysis would result from assumptions about depreciation in site values (see above), which does not appear to have been taken into account in the Kleinwort Benson calculations. Another analysis carried out by Credit Lyonnais (1991) found that, for a hypothetical Tesco develo p m e n t of 45 000 ft 2 sales area, the I R R would be affected only slightly by the length of the period assumed for site cost depreciation or by the rate of depreciation assumed. This is because net cash flow at the end of the period is heavily discounted and has little effect on the overall result. However, a 10% loss of retail sales from the projected 'mature' value would lower the IRR from 10.3% to 9.3%. Also significant was the gross margin: a reduction of only 0.1% from the assumed 24% would mean a reduction in I R R to 9.7%. The effects of any alteration in the assumed site cost of £10 million were not assessed in this exercise. The methods used by these and other analysts are based upon detailed knowledge of patterns of sales, costs and taxation. For example, the Credit Lyonnais method assumes some variation in annual retail sales, because of initial build-up of trade, subsequent competitive effects of other store openings, etc.
These variations are easily accommodated within the spreadsheet format used. However, academic researchers should be very wary in attempting to replicate such analyses, as they are unlikely to possess the full range of detailed financial knowledge and information available to the professional analyst. Instead, the following section investigates some simplified appraisal methods based upon Equations (1)-(3). The findings are unlikely to be reliable in detail but the use of a consistent simple method may suggest some general indications of relationships between the three key variables: land costs, retail sales and gross margin.
Further simulations The investment appraisal Equation as in (1) assumes knowledge of the desired IRR, and also either the initial or the final capital value of the site. The above discussion of depreciation of site costs does however allow a simplification of the equation. Suppose that the initial capital value (equivalent to site and development costs) is assumed to depreciate at a constant proportional rate of x pa over n years. Then CV~ = CV, L(I- x)"
(4)
Substituting in Equation (1) gives
Z c, CV,,-
~ (l+r) ~ 1 (l-x)" (1+ r)"
(5)
Thus initial development cost can be calculated from assumptions of rates of return and of depreciation, and from estimates of annual cash flows. This model can be used to estimate maximum site costs for an I R R of 10% using assumptions about cost factors, gross margins and sales similar to those used in the Credit Lyonnais (1991) worked example. Assume the example of a 45 000 ft: (sales area) store with a maximum annual sales of £40 million. Some six years after opening, the store's sales are hit by a new competitor. The following year there is a major refit costing £3 million, and also a smaller refit near the end of the store's life (15 years). In these latter years the store's turnover falls off somewhat owing to obsolescence. Initial building and fitting-out costs are assumed at £10 million. The worked example assumes no land cost depreciation: however, I have assumed annual depreciation of 2.5% and a target I R R of 10%. Following the Kleinwort Benson method, Equation (5) can be applied to various estimates of annual cash flow C, leading to different results: (1)
Ci is equated with operating profit. This includes the gross profit on sales (that is, sales times gross margin), minus labour costs and 29
C Guy Table 3 Simulation of site costs for typical superstores Type of store
Sales density (£/ft 2 pa)
Operating margin (%)
Max. site cost (£m)
Max. site cost per acre (£m)
'Store A':
Store of 40 000 ft 2 on 8 acre site. Construction cost £10 million
800 720 800 720
8 8 7 7
13.3 12.0 10.4 8.3
1.7 1.5 1.3 1.0
'Store B':
Store of 25 000 ft 2 on 6 acre site. Construction cost £8 million
800 720 800 720
8 8 7 7
6.5 5.1 4.7 3.5
1.1 0.9 0.8 0.6
(2)
other operating costs. Maximum land cost = £15.9 million or almost £2 million per acre. Ci is equated with total cash flow. This includes the above gross profit, labour costs and operating costs, but also takes into account the costs of the two refits, depreciation of the fittings, interest payments and taxation. Maximum land cost -- £13 million or about £1.6 million per acre.
These results appear to be fairly realistic, although well below the maxima suggested in Kleinwort Benson (1991), which were up to £22.5 million (see above). If we relax the assumption of 2.5% site cost depreciation the maximum site cost (based upon total cash flow calculations) then becomes £15.2 million. Possibly the Kleinwort Benson model does not take competitive effects etc into account, thus overestimating annual cash flows. In order to examine relationships between retail sales, site costs and profit margin in a more flexible manner, it is necessary to simplify the model embodied in Equation (5). This can be achieved if there is assumed to be no fluctuation in year-onyear sales (taking monetary inflation into account), and if net annual cash flow is assumed to simply consist of sales S multiplied by an operating margin OM. This will subsume the gross margin, labour costs, operating costs and tax. Thus: Ci = S • O M
(6)
Vi
Substituting in Equation (5) leads to "
CV, , = S . O M ~
25 000 ft 2 as developed increasingly in the last two years or so. The simulations involve reducing typical recent sales densities and operating margins by 10% and by one percentage point respectively. It appears that even in this narrow range of events, site costs could range from a maximum £1.7 million per acre down to only £600 000. It is also possible to devise an equation for a necessary minimum level of sales, given a particular land cost. Rearranging Equation (7), we get CV~ ,I1 S=
Table 4 Simulation of sales target for typical superstores Type of store
Site cost (£m)
Operating margin (%)
Min. sales pa (£m)
Min. sales density (£/ftz)
Store A
5 5 10 10 15 15 20 20
8 7 8 7 8 7 8 7
20.6 23.6 27.5 31.4 34.4 39.3 40.9 47.1
515 589 687 785 859 982 1022 1178
Store B
4 4 6 6 8 8 10 10
8 7 8 7 8 7 8 7
16.5 18.8 19.2 22.0 22.0 25.1 24.7 28.3
660 754 770 880 880 1005 989 1131
(7)
(l+r)"
30
(I + r)'
It is important to realize that this expression is not a forecast of sales. It is a minimum target, which would allow achievement of the desired rate of return, r. Increasing the initial cost, or decreasing the operating margin, necessitates higher target sales. It may seem odd that there is no reference to store size in this equation. However, as labour and operating costs are roughly proportional to store
1 (l-x)" This provides an estimate of the maximum initial costs that can be paid in order to achieve the desired IRR. From this, using Equation (2), maximum land costs can be determined. The method is explained in more detail in the Appendix to this paper. Table 3 shows some results for two typical store types: first, the 'conforming superstore' of 40 000 ft 2 sales area and, second, a smaller development of
(8)
'Z ' OM
l
(l+r)'
( l - x)"] (l+r)~ J
Retail store development at the margin Table 5 Simulation of site costs, with depreciation rate set at
Table 6 Simulation of sales target, with depreciation rate set at
5% pa
5% pa
Type of store
Sales density (~ft 2 pa)
Operating Max. site margin (%) cost (£m)
Max. site cost per acre (£m)
Type of store
Site cost (£m)
Operating margin (%)
Min. sales pa (£m)
Min. sales density (£/ft 2)
Store A
800 800 720 720
8 7 8 7
11.9 9.2 9.7 7.2
1.5 1.15 1.2 O.9
Store A
ll) 1I) 15 15
8 7 8, 7
29.2 33.4 36.5 41.7
731 835 913 1044
Store B
800 800 720 720
8 7 8 7
5.7 4.0 4.3 2.8
0.95 0.7 0.7 0.5
Store B
(~ ~,
8 7 8 7
20.5 23.4 23.4 26.7
818 935 935 1069
size, these factors are in effect included in the operating margin variable. The results of further simulations are shown in Table 4. Sales and trading densities are shown to vary according to site costs and operating margin, although the variation is not as wide as the variation in site costs, because it is assumed that construction costs remain constant throughout. The sales totals could easily be converted into estimates of minimum support population for the store, using methods discussed in Guy (1994b). It is also possible to explore the effects of more rapid depreciation of site value. Tables 5 and 6 show the simulated maximum site costs and minimum sales targets necessary if depreciation is assumed at 5% pa, rather than the 2.5% assumed previously. This would mean that the site was worth less than half of its original cost at the end of the 15-year period. The tables indicate, as expected, increased pressure on the store developer if this assumption is correct. For example, the larger store would, under favourable assumptions of sales levels and operating margin, have its maximum site costs reduced from £13.3 million (as in Table 3) to £11.9 million. The effects on sales densities (comparing Tables 4 and 6) are fairly modest.
Conclusions This paper began with an examination of some recent trends in grocery retailing in the UK. On the one hand it was shown that the performance of the Big Three and other major retailers appears to be faltering in some respects. The rise of the discounters is an important, if not the only, concern. On the other hand it appears that land prices for superstore development have recently fallen substantially. W h e t h e r this is the result of the major companies' reduction in store development programmes is not clear; but reduced demand for new sites, and a more careful approach towards new development, should inevitably mean that totem sites become much more rare and prices of land generally should fall.
b,
The quantitative analyses, while not attempting to match the retailers' own investment appraisal methods, are probably sufficiently realistic to indicate that lower land prices do in fact significantly widen the opportunities available to the major companies. At the same time the likely reduction in profit margins resulting from price wars will have the opposite effect in raising the level of retail sales necessary for successful store development. Accurate models of store competition at the local level will be more important than ever in determining both market penetration and price strategies for new stores. Further research needs to be undertaken in the appraisal methods outlined in this paper. It is important to refine these simplistic models so as to replicate actual decision making more closely, but the element of generality is also important. One possibility would be to model changes in sales over time, perhaps with some form of quadratic function. In more complex formulations it might be helpful to use differential calculus to estimate incremental changes in target sales, according to changes in margms, etc. The possibility of merging these methods with conventional sales forecasting methods involving regression or spatial interaction models could also be investigated. Finally, some conclusions for location theory itself. In superstore development, as in many other areas of property development, land costs are not determined exogenously but are driven by anticipated revenue and profitability from the site concerned. This is in fact quite consistent with Alonso's bid-rent theory but has tended to be ignored in the store location literature. A new insight however is that characteristics of the store's catchment area may affect not only total sales but also operating margins. The latter arises when there are one or more deep discounters trading within the catchment area, and this competition forces price cuts in the store concerned. It is not clear whether this eventuality is being built into investment appraisal methods although it could quite easily be done. Thus market penetration, price competition and land prices are interrelated and may also vary 31
C Guy considerably from one locality to the next. There would seem to be new opportunities for geographers and regional scientists to develop theoretical and empirical studies in this area. Acknowledgements I would like to thank Richard Gascoigne and Jonathan Reynolds for their help in obtaining much of the source material used in this paper. References Alonso, W (1964) Location and Land Use Harvard University Press, Cambridge, MA Baum, A and Crosby, N (1988) Property Investment Appraisal Routledge, London BDP Planning and Oxford Institute of Retail Management (1992) The Effects of Major Out of Town Retail Development: A Literature Review for the Department of the Environment HMSO, London: HMSO Brown, G R (1991) Property Investment and the Capital Markets E & F N Spon, London Burt, S and Sparks, L (1994) 'Structural change in grocery retailing: a discount reorientation?' International Review of Retail, Distribution and Consumer Research 4 195-217 Central Statistical Office (1994) Business Monitor Retailing SDA25 1991, HMSO, London Clarke, I, Bennison, D and Guy, C M (1994) 'The dynamics of UK grocery retailing at the local scale' International Journal of Retail and Distribution Management 22 (6) 11-20 Credit Lyonnais Laing (1991) Tesco plc: A Company Capitalising Too Much Interest? Credit Lyonnais Securities, London Credit Lyonnais Laing (1992a) How Much Hot Air Do You Like in Your Accounts? Food Retailer Property Valuations and Their Effect on the P & L Credit Lyonnais Securities, London Credit Lyonnais Laing (1992b) Property Again Credit Lyonnais Securities, London Davies, B K and Sparks, L (1989) 'The development of superstore retailing in Great Britain 1960-1986: results from a new database' Transactions of the Institute of British Geographers 14 74-89 Dubben, N and Sayce, S (1991) Property Portfolio Management: An Introduction Routledge, London Duke, R (1991) 'Post-saturation competition in UK grocery retailing' Journal of Marketing Management 7 63-75 Economist Intelligence Unit (1993a) 'Trade review 1: grocery retailers' E1U Retail Trade Review 28 7-29 Economist Intelligence Unit (1993b) 'Company profile 2: Tesco' EIU Retail Trade Review 28 78-81 Fraser, W D (1984) Principles of Property Investment and Pricing Macmillan, Basingstoke Gascoigne, R (1992) 'The entry of European limited line discounters into the United Kingdom' Paper presented at the Institute of British Geographers' Annual Conference. Available from author at Department of Geography, University of Southampton, Southampton SO9 5NH, UK Gayler, H J (1984) Retail Innovation in Britain: The Problems of Out-of-Town Shopping Centre Development Geo Books, Norwich Ghosh, A and McLafferty, S (1987) Location Strategies for Retail and Service Firms Lexington Books, Lexington Guy, C M (1987) 'The assessment of retail impact' The Planner 73 (12) 31-34 Guy, C M (1994a) The Retail Development Process Routledge, London Guy, C M (1994b) 'Grocery store saturation: has it arrived yet?' International Journal of Retail and Distribution Management 22 (1) 3-11 Hargitay, S E and Yu, S-M (1993) Property Investment Decisions: A Quantitative Approach E & F N Spon, London Henderson Crosthwaite (1992) Food Retail No 10 London
32
Hogarth-Scott, S and Rice, S P (1994) 'The new food discounters: are they a threat to the major multiples?' International Journal of Retail and Distribution Management 22 (1) 20-28 Jones, P (1981) 'Retail innovation and diffusion - the spread of Asda stores' Area 13 197-201 Kleinwort Benson (1991) Food Retailing: Survival of the Fittest Kleinwort Benson Securities, London Myers, B (1992) 'City judgements' The Grocer (19 September) 28-29 Penny, N J and Broom, D (1988) 'The Tesco approach to store location' in Wrigley, N (ed) Store Choice, Store Location and Market Analysis Routledge, Routledge, 106-119 J Sainsbury plc (nd) Sainsbury's Store Development Study Notes (study pack information), London J Sainsbury plc (1994) Annual Report and Accounts 1994, London Schmidt, R A, Segal, R and Cartwright, C (1994) "Two-stop shopping or polarization: whither UK grocery shopping?' International Journal of Retail and Distribution Management 22 (1) 12-19 Strauss Turnbull (1994) Tesco Socirt6 G6nrrale Strauss Turnbull Securities, London Tesco plc (1994) Annual Report and Accounts 1994 Cheshunt Thorpe, D (1991) 'The development of British superstore retailing - further comments on Davies and Sparks' Transactions of the Institute of British Geographers 16 354-367 Treadgold, A D and Reynolds, J (1989) Retail Saturation: Examining the Evidence Longman, Longman Unit for Retail Planning Information (1993) 1993 Register of UK Hypermarkets and Superstores The Unit, Reading Wrigley, N (1988) Store Choice, Store Location and Market Analysis Routledge, London Wrigley, N (1991) 'Is the "golden age" of British grocery retailing at a watershed?' Environment and Planning A 23 1537-1544 Wrigley, N (1992) 'Sunk capital, the property crisis, and the restructuring of British food retailing' Environment and Planning A 24 1521-1527 Wrigley, N (1993) 'The internationalisation of British grocery retailing' in Bromley, R D F and Thomas, C J (eds) Retail Change: Contemporary Issues UCL Press, London, 41-68 Wrigley, N (1994) 'After the store wars: towards a new era of competition in UK food retailing?' Journal of Retailing and Consumer Services 1 (1) 5-20
Appendix Calculation o f m a x i m u m site costs for conforming superstore A s s u m e that a store of 40 000 ft 2 sales area is to be developed on a site of 8 acres. Construction costs are £10 million. Average annual sales are estimated at £800/ft z and the operating margin is assumed at 8% of sales. The intention is to generate an I R R of 10% and the store's life is assumed as 15 years. The site value is to depreciate at 2.5% per annum. Thus S OM
r x n
= £(800 × 40 000) = £32 000 000 (annual sales) = 0.08 (operating margin) = 0.1 (IRR) = 0.025 (depreciation) = 15 (life of the store)
Application of Equation (7) leads to C V , I = £23 280 000. Deduct the £10 million construction costs to give a site cost of £13.3 million.
U T T E R W O R T H E I N E M A N
Journal of Retailing and Consumer Services Vol 2, No 1, pp. 25-32, 1995 Copyright © 1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0969-6989/95 $10.00 + .00
N
0969-6989(95)00030-5
Retail store development at the margin Clifford Guy Department of City and Regional Planning, University of Wales College of Cardiff: PO Box 906, Cardiff CFI 3YN, Wales, UK This paper explores some outcomes of current financial and market pressures on grocery superstore developers in the UK. Relationships between the size of a store, its net profit margin, and the land costs involved are examined through simplified methods of investment appraisal. It is shown that increased levels of competition, from both superstores and discount grocery stores, are likely to drive down bids for land from the very high levels seen at the end of the 1980s. Empirical investigation suggests that this process is already occurring. Practical and theoretical implications of these findings are discussed. K e y w o r d s : g r o c e r y stores, s u p e r s t o r e s , land costs
The development programmes of large grocery stores in the UK have stimulated research among retail analysts, geographers and town planners for many years. Between 1967 and the beginning of 1993, some 776 'true" grocery superstores of at least 2500 m 2 sales area were opened, and a further 101 had received planning permission (URPI, 1993). At least 100 slightly smaller stores showing similar characteristics also exist. This scale of development has encouraged spatial analysts to map the diffusion of large stores across the UK, and the changing competitive structure of mass market grocery retailing (eg Jones, 1981; Davies and Sparks, 1989; Thorpe, 1991; Wrigley, 1993). A second major research focus has been on the economic impact of large new stores upon smaller stores and traditional shopping centres, and the implications for town planners (eg Gayler, 1984; Guy, 1987; BDP Planning, 1992). One of the key issues here has been the availability of land for new store development. Most of the debate has focused on the restrictions on land availability that result from town planning policy. However, a related but much less studied issue lies in the distortions to the land market itself that have resulted from the ambitious development programmes of the major superstore operators. Extreme competition for good-quality sites with planning permission has resulted in hoarding of land and inflated prices. This in turn has reduced the profitability of new store development and has led to criticism of the grocery multiples by institutional investors.
This paper examines in particular the land market for superstore development and ways in which land prices affect, or are affected by, the viability of new store development. As there seems to be little existing academic work on this topic, the examination is exploratory and there is little discussion of empirical evidence. The analysis of store development and land costs relies on methods of appraisal routinely used in both property development and financial forecasting. The paper demonstrates that land costs, a topic largely ignored in the literature on store location, are important in their own right and can be both cause and effect of changes in store development programmes. Recent changes in grocery store development in the U K The late 1980s appear in retrospect to have been the 'golden age' of grocery store development in Britain (Wrigley, 1991, 1994). Rates of superstore development increased as it became clear how popular such stores were with shoppers. An increasingly liberal town planning regime made off-centre sites easier to obtain. At the same time several large companies moved up market and emphasized variety and quality of grocery products rather than price. This enabled operating margins to increase from around 3-5% in the mid 1980s to around 6-8% in 1992 (Henderson Crosthwaite, 1992). These margins are much higher than in the rest of western Europe or in North America, where 1-2% is more common. 25
C Guy
Towards the end of the 1980s, major structural changes occurred in British grocery retailing. Two major companies, Asda and Gateway, were for financial reasons forced to call a virtual halt to their superstore development programmes. Superstore development thus became concentrated mainly within just three companies: Tesco, Sainsbury and Safeway (part of the Argyll Group). The profitability of superstore development encouraged these retailers to accelerate their store development programmes. Extra finance was raised through rights issues and sale-and-leaseback arrangements (Wrigley, 1991; Guy, 1994a). Until very recently, each company intended to open at least 25 new large stores every year for the foreseeable future, stating that literally hundreds of new sites were being seriously considered (Guy, 1994b). These plans have been thrown into doubt by an increasing realization that market saturation has arrived or is imminent in many parts of the UK. Although this was much anticipated in the analytical literature (eg Treadgold and Reynolds, 1989; Duke, 1991; Guy, 1994a, 1994b), it was only around the beginning of 1994 that the Big Three themselves appeared to recognize that their expansion could not be maintained indefinitely. Stores were already being developed in areas where previously the catchment population had been perceived as too small to warrant a large grocery store. It appears now that development programmes are to be cut back to around 20 stores per annum. These will include stores smaller than the conventional superstore in market towns, plus a few much smaller town centre stores, which will be targeted at the town centre employee for convenience food purchases (Clarke et al, 1994). A further major issue has been the rise of the 'discount' store in the UK (Gascoigne, 1992; Wrigley, 1993; Burt and Sparks, 1994). At the end of the 1980s several western European retailers became interested in the UK market. They perceived a new opportunity to sell limited ranges of goods to price-conscious shoppers. Prices were kept low by accepting low margins; by developing cheap 'no-frills' stores in cheap locations; and by selling own-brand or 'tertiary brand' goods, which did not carry the promotion and marketing overheads of the top branded goods. These retailers were thus able to undercut the Big Three's superstore prices substantially. The leading British discounter, Kwik Save, responded to these new threats by expanding its store development programme and by attempting to compete where necessary on price terms with the new 'European' discounters, Aldi and Netto.
Pressures on the superstore developers In contrast with their counterparts in several other European countries, the major grocery retailers in 26
Table 1 Grocery company share values, 1993-94 Company
Share price 8 April 1994
1993 Highest share price
1994 Lowest share price
Sainsbury Tesco Argyll Group Asda Group
362 212 250 57
480 254 306 66
342 210 240 55
Source: Sunday Times, 10 April 1994
the UK are mostly public limited companies, whose performance is subject to constant scrutiny by institutional investors and City analysts. This helps to provide a rich source of up-to-date information and expert opinion, some of which is discussed later in this paper. It also puts the major companies under considerable pressure to maximize short-term as well as long-term returns on investment (Myers, 1992). What may appear to the outside observer as minor fluctuations in performance or threats for the future can have a major effect upon share prices. At the time of writing, share prices for the Big Three and Asda are very low by recent standards (Table 1). The reasons for this are briefly as follows. First, there is the concern over market saturation. Rising sales and profits have been based upon the expansion of floor area through the store development programme. Year-on-year increases in sales and profits through existing stores have in recent years been very modest and, in the case of Sainsbury and Safeway in 1992-93, appear to have actually been below the rate of food price inflation (EIU, 1993a). Growth in sales is thus created very largely by new store development. Any reduction in store development programmes - or a switch to development of smaller stores - suggests slower future increases in sales. Furthermore, recently opened stores appear to record lower sales per square metre than stores opened in previous years (Henderson Crosthwaite, 1992). Second, there is the impact of the discounters. The extent and nature of this impact are not yet clear. Recent research suggests that discounters are more likely to compete with each other than with the superstore retailers (Hogarth-Scott and Rice, 1994; Schmidt et al, 1994). However, evidence from the Manchester and Cardiff areas suggests a consistent switch in custom from the Big Three to Kwik Save and other discounters in the last three years (Clarke et al, 1994). Certainly the City has been concerned over this issue. The Big Three have in various ways made some gestures towards reducing prices. This may help to retain or attract custom but it is likely to lower the companies' operating margins. Third, the Big Three companies and (at one time) Asda have been criticized for paying high prices for the land required for new store development. Sainsbury and Tesco are seen as the major culprits. This issue is discussed in the next section.
Retail store development at the margin
Fourth, certain accounting devices used by the major retailers have been roundly criticized by City commentators and have been adjusted recently to meet these criticisms. This has reduced the apparent profitability of the companies. The much-criticized device of capitalization of interest paid on loans to finance store development has been discussed by Credit Lyonnais Laing (1991) and Wrigley (1992), and need not concern us here. Conventions in the valuation of property holdings have also been under discussion and these are relevant to the arguments presented later in this paper. Briefly, the question is whether the companies' land holdings, especially those on which superstores have been built, should continue to be valued at cost price plus monetary inflation, or should be assumed to depreciate over time. The latter is normal practice in company accounting. The question is particularly important for superstore retailers because there is clear evidence, discussed below, that the retailers have paid much more for land in recent years than other land users would have done. The first major grocery company to accept City criticism and allow depreciation on property holdings was Wm Morrison in 1992. The other major companies have now followed suit, despite the reduction in their apparent assets that results from this decision (Credit Lyonnais Laing, 1992a, 1992b). In addition, they have made one-off writedowns in the value of their property to acknowledge previous overpayment for sites. For example, in the financial year 1993-94 Sainsbury wrote down £341.5 million of property values, of which £282.4 million was in respect of the 'value of land element of trading properties" ISainsbury, 1994, p 51).
located outer suburban sites with appropriate planning permission in south Wales in early 1994. During the late 1980s the prices paid by grocery companies rose rapidly as competition became more intense. Certain 'totem sites' in the south-east of England were purchased for between £2 and £3 million per acre by Sainsbury, Tesco and Asda (Kleinwort Benson, 1991). At this time the difference between superstore site values and other retail was substantially higher than that shown in Table 2. For example, prices for retail warehouse sites were typically no more than £500 000 per acre or perhaps at maximum £1 million per acre in southeast England. Typical superstore land prices continued to rise between 1989 and 1991, when the remainder of the property market was in serious slump condition (Credit Lyonnais, 1992a). More recently, superstore site prices appear to have fallen, to typically between about £300 000 and £1.25 million per acre, but they are still above typical retail warehouse site prices. There is great variation in superstore land prices, which reflects not only the quality of the site but local property conditions generally plus a substantial 'chance' element. The highest prices appear to occur when more than one operator is interested and a competitive bidding process ensues. It is sometimes necessary to add to these very high prices further costs related to planning gain extracted by local authorities in return for allowing planning permission (Guy, 1994a). The cost of land is not only a major part of total development costs, as shown in the next section: it also ties up the company's capital during an unproductive period while the site remains in the company's "land bank'.
Superstore land costs
Land costs and the investment decision Any company wishing to carry out property development should carry out some form of investment appraisal. Typical methods are described in Baum and Crosby (1988), Brown (1991), Dubben and Sayce (1991), Hargitay and Yu (1993), and Fraser (1984). The intention should be to achieve some suitable rate of financial return from the investment, over a period of years. The four components in the appraisal are:
It is well known that the price of an area of land can vary according to the existing or proposed use of that area. Many writers, including Alonso (1964), have shown that commercial users value accessibility particularly highly, and are likely thus to 'capture' the most accessible areas in an urban system through the competitive bidding process. It may not be as obvious that different commercial or even different retail users will be willing to pay significantly different amounts for the same land. This competitive bidding takes place in outer suburban locations rather than the central city areas emphasized by Alonso. Table 2 shows typical prices paid for well-
(1)
(2) Table 2 Typical land values in South Wales Type of land use
Value (£'000 per acre)
Agricultural Residential Retail warehouse park Grocery superstore
1 200 300 500-1000
(3) (4)
the capital value of the site at the beginning of the period, CV, ~, which can for the owner-occupier be equated with initial development costs, including site costs and construction costs: the capital value of the developed site at the end of the period, CV; the net cash flow derived each year (i) from the completed development, C/; the internal rate of return (IRR) to be derived from the investment, usually expressed as an annual percentage of the initial development costs, r. 27
C Guy
These components are related to one another in the equation
CV,_,
-
C V~ Ci + ~_~ (l+r)" i=l ( l + r ) i
(1)
where n is the total period in years (Hargitay and Yu, 1993, p 207). The first term on the right-hand side of the equation represents the discounted value of the capital value at the end of the period, and the second term represents the sum of discounted cash flows (DCFs) throughout the period. This type of analysis can be used in two ways. First, an internal rate of return can be assumed in advance, typically in property transactions at the current rate of return available in Government giltedged securities, plus a premium of at least 2% to cover the risk associated with property investment (Dubben and Sayce, 1991). The equation is then used to determine the capital value that will just provide that IRR. From this value, construction and other costs are deducted to produce a residual estimate of land costs. The developer will then be willing to bid up to this amount when attempting to buy the land. A second use of this equation is to calculate the I R R that would result from a given initial expenditure, CV,_~. Frequently the developer is offered a site at a fixed price, and it is necessary to find out whether an adequate rate of return is likely to result. Clearly, r cannot be calculated directly from Equation (1), but valuation tables can be used to provide an approximate estimate of r. These methods are normally used in appraising speculative property developments, such as office blocks or regional shopping centres, in which the income will be derived from rents paid by future tenants. It should also be expected that the capital value of the scheme at the end of the period is as much as or greater than the initial capital value. In appraising any retail scheme in which the developer is also destined to be the retailer, there are two major differences from conventional property schemes. First, incomes are derived directly from retail sales, converted into profit through application of a gross margin on sales. The gross margin is to some extent a strategic choice of the retailer, but sales depend upon the size and characteristics of the store's catchment area. Second, the final capital value of the site (including the store itself) is unlikely to be as much as the initial development cost (Credit Lyonnais, 1992a). This is partly because the store itself will to some extent become obsolete, and partly because the company may have paid a premium over normal retail land prices in the first instance (see above). This has been reflected in recent decisions of the Big Three to depreciate their land holdings, although the rate of deprecia28
tion (2% pa for Sainsbury, and 2E% for Tesco) has been criticized as being too low (Strauss Turnbull, 1994). Naturally, the major retailers do not seek to publicize their own investment appraisal methods. However, it is known that each proposed new superstore is subject to an appraisal in its own right. Typically the retailer will estimate potential sales at the site, using a gravity model (Penny and Broom, 1988) or some other method, and then estimate how much it can afford to pay for the land: Supermarket operators evaluate each individual site by attempting to predict the turnover that would be achieved if they were to build there. The turnover will determine the amount that can be paid for the land.' (Sainsbury, nd) City analysts such as Kleinwort Benson (1991) and Credit Lyonnais (1992a) have attempted to replicate this type of appraisal in order to judge the prospects for profit growth among the retailers. Their models, which are stated to be similar to those used by the major companies, rely on year-by-year projections of sales and costs in a typical superstore. Some sensitivity analyses derived from these models are discussed in the following section. Two general modifications of the basic appraisal model (Equation (1)) can be derived from their analyses. First, initial capital value is composed of land cost plus construction cost: CV, i = L C + C C
(2)
Second, net cash flow per annum is composed of sales mediated through the gross margin (expressed as a proportion of sales), less labour costs and operating costs: Ci = S i G M i - L C i - O C i
(3)
where G M i is the gross margin for year ii, expressed as a proportion of sales rather than the usual percentage value. It is clear from this discussion that sales, gross margin and land costs are all vital ingredients in determining the viability of a superstore. The latter two are often neglected in the literature on store location, which emphasizes sales forecasting as a major input to the store location decision (eg Ghosh and McLafferty, 1987; Wrigley, 1988). Simulation of the investment decision
Kleinwort Benson (1991, p 30) examined the maximum land cost that a major retailer might reasonably pay for a site sufficient to develop a store of 66 000 ft 2 gross retail area. Using information on typical ratios of sales per square foot, and typical values of gross margin and of other cost factors, the following land costs would just allow an 'acceptable' DCF return of 10% (adjusted for tax and inflation):
Retail store development at the margin Tesco Sainsbury Argyll Asda
£22.5 £19.8 £15.5 £10.6
million million million million
The site required would be about 8 acres, to include some 600-700 car parking spaces, petrol filling station, etc. This indicates that the costs of £2-3 million per acre being paid in exceptional cases at that time would still just about have allowed a viable development for Sainsbury and Tesco. The difference between the four companies' ability to pay land costs lay partly in their different ratios of sales per square foot, but also in different ratios of sales area to gross area: Tesco was at that time able to 'squeeze' more sales area out of a given size of building. Since 1991 several elements have changed. While labour and operating costs have risen slightly, the important change that has led the commentators to revise such estimates has been the reduced amount of sales projected for a typical new store, given that the companies are now developing poorer sites as saturation looms. In addition, the impact of the discounters means that gross margins are likely to be reduced from the very high levels of the early 1990s. G o v e r n m e n t statistics show that gross margins of large grocery retailers rose from 18.0% of tax-exclusive turnover in 1980 to 24.2% in 1991 (Central Statistical Office, 1994, Table 3). More recent data are not available, but Tesco have revealed that their gross margin fell by 0.4% in 1993-94 (Tesco, 1994, p 16). Thus the growth in margins characteristic of the 1980s may now be reversed because of the need for multiples to introduce more price-cutting lines (see also EIU, 1993b, p.79). A third change in the analysis would result from assumptions about depreciation in site values (see above), which does not appear to have been taken into account in the Kleinwort Benson calculations. Another analysis carried out by Credit Lyonnais (1991) found that, for a hypothetical Tesco develo p m e n t of 45 000 ft 2 sales area, the I R R would be affected only slightly by the length of the period assumed for site cost depreciation or by the rate of depreciation assumed. This is because net cash flow at the end of the period is heavily discounted and has little effect on the overall result. However, a 10% loss of retail sales from the projected 'mature' value would lower the IRR from 10.3% to 9.3%. Also significant was the gross margin: a reduction of only 0.1% from the assumed 24% would mean a reduction in I R R to 9.7%. The effects of any alteration in the assumed site cost of £10 million were not assessed in this exercise. The methods used by these and other analysts are based upon detailed knowledge of patterns of sales, costs and taxation. For example, the Credit Lyonnais method assumes some variation in annual retail sales, because of initial build-up of trade, subsequent competitive effects of other store openings, etc.
These variations are easily accommodated within the spreadsheet format used. However, academic researchers should be very wary in attempting to replicate such analyses, as they are unlikely to possess the full range of detailed financial knowledge and information available to the professional analyst. Instead, the following section investigates some simplified appraisal methods based upon Equations (1)-(3). The findings are unlikely to be reliable in detail but the use of a consistent simple method may suggest some general indications of relationships between the three key variables: land costs, retail sales and gross margin.
Further simulations The investment appraisal Equation as in (1) assumes knowledge of the desired IRR, and also either the initial or the final capital value of the site. The above discussion of depreciation of site costs does however allow a simplification of the equation. Suppose that the initial capital value (equivalent to site and development costs) is assumed to depreciate at a constant proportional rate of x pa over n years. Then CV~ = CV, L(I- x)"
(4)
Substituting in Equation (1) gives
Z c, CV,,-
~ (l+r) ~ 1 (l-x)" (1+ r)"
(5)
Thus initial development cost can be calculated from assumptions of rates of return and of depreciation, and from estimates of annual cash flows. This model can be used to estimate maximum site costs for an I R R of 10% using assumptions about cost factors, gross margins and sales similar to those used in the Credit Lyonnais (1991) worked example. Assume the example of a 45 000 ft: (sales area) store with a maximum annual sales of £40 million. Some six years after opening, the store's sales are hit by a new competitor. The following year there is a major refit costing £3 million, and also a smaller refit near the end of the store's life (15 years). In these latter years the store's turnover falls off somewhat owing to obsolescence. Initial building and fitting-out costs are assumed at £10 million. The worked example assumes no land cost depreciation: however, I have assumed annual depreciation of 2.5% and a target I R R of 10%. Following the Kleinwort Benson method, Equation (5) can be applied to various estimates of annual cash flow C, leading to different results: (1)
Ci is equated with operating profit. This includes the gross profit on sales (that is, sales times gross margin), minus labour costs and 29
C Guy Table 3 Simulation of site costs for typical superstores Type of store
Sales density (£/ft 2 pa)
Operating margin (%)
Max. site cost (£m)
Max. site cost per acre (£m)
'Store A':
Store of 40 000 ft 2 on 8 acre site. Construction cost £10 million
800 720 800 720
8 8 7 7
13.3 12.0 10.4 8.3
1.7 1.5 1.3 1.0
'Store B':
Store of 25 000 ft 2 on 6 acre site. Construction cost £8 million
800 720 800 720
8 8 7 7
6.5 5.1 4.7 3.5
1.1 0.9 0.8 0.6
(2)
other operating costs. Maximum land cost = £15.9 million or almost £2 million per acre. Ci is equated with total cash flow. This includes the above gross profit, labour costs and operating costs, but also takes into account the costs of the two refits, depreciation of the fittings, interest payments and taxation. Maximum land cost -- £13 million or about £1.6 million per acre.
These results appear to be fairly realistic, although well below the maxima suggested in Kleinwort Benson (1991), which were up to £22.5 million (see above). If we relax the assumption of 2.5% site cost depreciation the maximum site cost (based upon total cash flow calculations) then becomes £15.2 million. Possibly the Kleinwort Benson model does not take competitive effects etc into account, thus overestimating annual cash flows. In order to examine relationships between retail sales, site costs and profit margin in a more flexible manner, it is necessary to simplify the model embodied in Equation (5). This can be achieved if there is assumed to be no fluctuation in year-onyear sales (taking monetary inflation into account), and if net annual cash flow is assumed to simply consist of sales S multiplied by an operating margin OM. This will subsume the gross margin, labour costs, operating costs and tax. Thus: Ci = S • O M
(6)
Vi
Substituting in Equation (5) leads to "
CV, , = S . O M ~
25 000 ft 2 as developed increasingly in the last two years or so. The simulations involve reducing typical recent sales densities and operating margins by 10% and by one percentage point respectively. It appears that even in this narrow range of events, site costs could range from a maximum £1.7 million per acre down to only £600 000. It is also possible to devise an equation for a necessary minimum level of sales, given a particular land cost. Rearranging Equation (7), we get CV~ ,I1 S=
Table 4 Simulation of sales target for typical superstores Type of store
Site cost (£m)
Operating margin (%)
Min. sales pa (£m)
Min. sales density (£/ftz)
Store A
5 5 10 10 15 15 20 20
8 7 8 7 8 7 8 7
20.6 23.6 27.5 31.4 34.4 39.3 40.9 47.1
515 589 687 785 859 982 1022 1178
Store B
4 4 6 6 8 8 10 10
8 7 8 7 8 7 8 7
16.5 18.8 19.2 22.0 22.0 25.1 24.7 28.3
660 754 770 880 880 1005 989 1131
(7)
(l+r)"
30
(I + r)'
It is important to realize that this expression is not a forecast of sales. It is a minimum target, which would allow achievement of the desired rate of return, r. Increasing the initial cost, or decreasing the operating margin, necessitates higher target sales. It may seem odd that there is no reference to store size in this equation. However, as labour and operating costs are roughly proportional to store
1 (l-x)" This provides an estimate of the maximum initial costs that can be paid in order to achieve the desired IRR. From this, using Equation (2), maximum land costs can be determined. The method is explained in more detail in the Appendix to this paper. Table 3 shows some results for two typical store types: first, the 'conforming superstore' of 40 000 ft 2 sales area and, second, a smaller development of
(8)
'Z ' OM
l
(l+r)'
( l - x)"] (l+r)~ J
Retail store development at the margin Table 5 Simulation of site costs, with depreciation rate set at
Table 6 Simulation of sales target, with depreciation rate set at
5% pa
5% pa
Type of store
Sales density (~ft 2 pa)
Operating Max. site margin (%) cost (£m)
Max. site cost per acre (£m)
Type of store
Site cost (£m)
Operating margin (%)
Min. sales pa (£m)
Min. sales density (£/ft 2)
Store A
800 800 720 720
8 7 8 7
11.9 9.2 9.7 7.2
1.5 1.15 1.2 O.9
Store A
ll) 1I) 15 15
8 7 8, 7
29.2 33.4 36.5 41.7
731 835 913 1044
Store B
800 800 720 720
8 7 8 7
5.7 4.0 4.3 2.8
0.95 0.7 0.7 0.5
Store B
(~ ~,
8 7 8 7
20.5 23.4 23.4 26.7
818 935 935 1069
size, these factors are in effect included in the operating margin variable. The results of further simulations are shown in Table 4. Sales and trading densities are shown to vary according to site costs and operating margin, although the variation is not as wide as the variation in site costs, because it is assumed that construction costs remain constant throughout. The sales totals could easily be converted into estimates of minimum support population for the store, using methods discussed in Guy (1994b). It is also possible to explore the effects of more rapid depreciation of site value. Tables 5 and 6 show the simulated maximum site costs and minimum sales targets necessary if depreciation is assumed at 5% pa, rather than the 2.5% assumed previously. This would mean that the site was worth less than half of its original cost at the end of the 15-year period. The tables indicate, as expected, increased pressure on the store developer if this assumption is correct. For example, the larger store would, under favourable assumptions of sales levels and operating margin, have its maximum site costs reduced from £13.3 million (as in Table 3) to £11.9 million. The effects on sales densities (comparing Tables 4 and 6) are fairly modest.
Conclusions This paper began with an examination of some recent trends in grocery retailing in the UK. On the one hand it was shown that the performance of the Big Three and other major retailers appears to be faltering in some respects. The rise of the discounters is an important, if not the only, concern. On the other hand it appears that land prices for superstore development have recently fallen substantially. W h e t h e r this is the result of the major companies' reduction in store development programmes is not clear; but reduced demand for new sites, and a more careful approach towards new development, should inevitably mean that totem sites become much more rare and prices of land generally should fall.
b,
The quantitative analyses, while not attempting to match the retailers' own investment appraisal methods, are probably sufficiently realistic to indicate that lower land prices do in fact significantly widen the opportunities available to the major companies. At the same time the likely reduction in profit margins resulting from price wars will have the opposite effect in raising the level of retail sales necessary for successful store development. Accurate models of store competition at the local level will be more important than ever in determining both market penetration and price strategies for new stores. Further research needs to be undertaken in the appraisal methods outlined in this paper. It is important to refine these simplistic models so as to replicate actual decision making more closely, but the element of generality is also important. One possibility would be to model changes in sales over time, perhaps with some form of quadratic function. In more complex formulations it might be helpful to use differential calculus to estimate incremental changes in target sales, according to changes in margms, etc. The possibility of merging these methods with conventional sales forecasting methods involving regression or spatial interaction models could also be investigated. Finally, some conclusions for location theory itself. In superstore development, as in many other areas of property development, land costs are not determined exogenously but are driven by anticipated revenue and profitability from the site concerned. This is in fact quite consistent with Alonso's bid-rent theory but has tended to be ignored in the store location literature. A new insight however is that characteristics of the store's catchment area may affect not only total sales but also operating margins. The latter arises when there are one or more deep discounters trading within the catchment area, and this competition forces price cuts in the store concerned. It is not clear whether this eventuality is being built into investment appraisal methods although it could quite easily be done. Thus market penetration, price competition and land prices are interrelated and may also vary 31
C Guy considerably from one locality to the next. There would seem to be new opportunities for geographers and regional scientists to develop theoretical and empirical studies in this area. Acknowledgements I would like to thank Richard Gascoigne and Jonathan Reynolds for their help in obtaining much of the source material used in this paper. References Alonso, W (1964) Location and Land Use Harvard University Press, Cambridge, MA Baum, A and Crosby, N (1988) Property Investment Appraisal Routledge, London BDP Planning and Oxford Institute of Retail Management (1992) The Effects of Major Out of Town Retail Development: A Literature Review for the Department of the Environment HMSO, London: HMSO Brown, G R (1991) Property Investment and the Capital Markets E & F N Spon, London Burt, S and Sparks, L (1994) 'Structural change in grocery retailing: a discount reorientation?' International Review of Retail, Distribution and Consumer Research 4 195-217 Central Statistical Office (1994) Business Monitor Retailing SDA25 1991, HMSO, London Clarke, I, Bennison, D and Guy, C M (1994) 'The dynamics of UK grocery retailing at the local scale' International Journal of Retail and Distribution Management 22 (6) 11-20 Credit Lyonnais Laing (1991) Tesco plc: A Company Capitalising Too Much Interest? Credit Lyonnais Securities, London Credit Lyonnais Laing (1992a) How Much Hot Air Do You Like in Your Accounts? Food Retailer Property Valuations and Their Effect on the P & L Credit Lyonnais Securities, London Credit Lyonnais Laing (1992b) Property Again Credit Lyonnais Securities, London Davies, B K and Sparks, L (1989) 'The development of superstore retailing in Great Britain 1960-1986: results from a new database' Transactions of the Institute of British Geographers 14 74-89 Dubben, N and Sayce, S (1991) Property Portfolio Management: An Introduction Routledge, London Duke, R (1991) 'Post-saturation competition in UK grocery retailing' Journal of Marketing Management 7 63-75 Economist Intelligence Unit (1993a) 'Trade review 1: grocery retailers' E1U Retail Trade Review 28 7-29 Economist Intelligence Unit (1993b) 'Company profile 2: Tesco' EIU Retail Trade Review 28 78-81 Fraser, W D (1984) Principles of Property Investment and Pricing Macmillan, Basingstoke Gascoigne, R (1992) 'The entry of European limited line discounters into the United Kingdom' Paper presented at the Institute of British Geographers' Annual Conference. Available from author at Department of Geography, University of Southampton, Southampton SO9 5NH, UK Gayler, H J (1984) Retail Innovation in Britain: The Problems of Out-of-Town Shopping Centre Development Geo Books, Norwich Ghosh, A and McLafferty, S (1987) Location Strategies for Retail and Service Firms Lexington Books, Lexington Guy, C M (1987) 'The assessment of retail impact' The Planner 73 (12) 31-34 Guy, C M (1994a) The Retail Development Process Routledge, London Guy, C M (1994b) 'Grocery store saturation: has it arrived yet?' International Journal of Retail and Distribution Management 22 (1) 3-11 Hargitay, S E and Yu, S-M (1993) Property Investment Decisions: A Quantitative Approach E & F N Spon, London Henderson Crosthwaite (1992) Food Retail No 10 London
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Hogarth-Scott, S and Rice, S P (1994) 'The new food discounters: are they a threat to the major multiples?' International Journal of Retail and Distribution Management 22 (1) 20-28 Jones, P (1981) 'Retail innovation and diffusion - the spread of Asda stores' Area 13 197-201 Kleinwort Benson (1991) Food Retailing: Survival of the Fittest Kleinwort Benson Securities, London Myers, B (1992) 'City judgements' The Grocer (19 September) 28-29 Penny, N J and Broom, D (1988) 'The Tesco approach to store location' in Wrigley, N (ed) Store Choice, Store Location and Market Analysis Routledge, Routledge, 106-119 J Sainsbury plc (nd) Sainsbury's Store Development Study Notes (study pack information), London J Sainsbury plc (1994) Annual Report and Accounts 1994, London Schmidt, R A, Segal, R and Cartwright, C (1994) "Two-stop shopping or polarization: whither UK grocery shopping?' International Journal of Retail and Distribution Management 22 (1) 12-19 Strauss Turnbull (1994) Tesco Socirt6 G6nrrale Strauss Turnbull Securities, London Tesco plc (1994) Annual Report and Accounts 1994 Cheshunt Thorpe, D (1991) 'The development of British superstore retailing - further comments on Davies and Sparks' Transactions of the Institute of British Geographers 16 354-367 Treadgold, A D and Reynolds, J (1989) Retail Saturation: Examining the Evidence Longman, Longman Unit for Retail Planning Information (1993) 1993 Register of UK Hypermarkets and Superstores The Unit, Reading Wrigley, N (1988) Store Choice, Store Location and Market Analysis Routledge, London Wrigley, N (1991) 'Is the "golden age" of British grocery retailing at a watershed?' Environment and Planning A 23 1537-1544 Wrigley, N (1992) 'Sunk capital, the property crisis, and the restructuring of British food retailing' Environment and Planning A 24 1521-1527 Wrigley, N (1993) 'The internationalisation of British grocery retailing' in Bromley, R D F and Thomas, C J (eds) Retail Change: Contemporary Issues UCL Press, London, 41-68 Wrigley, N (1994) 'After the store wars: towards a new era of competition in UK food retailing?' Journal of Retailing and Consumer Services 1 (1) 5-20
Appendix Calculation o f m a x i m u m site costs for conforming superstore A s s u m e that a store of 40 000 ft 2 sales area is to be developed on a site of 8 acres. Construction costs are £10 million. Average annual sales are estimated at £800/ft z and the operating margin is assumed at 8% of sales. The intention is to generate an I R R of 10% and the store's life is assumed as 15 years. The site value is to depreciate at 2.5% per annum. Thus S OM
r x n
= £(800 × 40 000) = £32 000 000 (annual sales) = 0.08 (operating margin) = 0.1 (IRR) = 0.025 (depreciation) = 15 (life of the store)
Application of Equation (7) leads to C V , I = £23 280 000. Deduct the £10 million construction costs to give a site cost of £13.3 million.