In the second of a two-part essay on the implications of inflation and rising costs in Singapore, IPS Adjunct Senior Research Fellow Manu Bhaskaran and Research Assistant Ng Yan Hao ask if rental costs have contributed substantially to rising inflation in Singapore and how policy tweaks can help business owners. Read the first essay here.
Rents of Retail Space
Rising retail, commercial and industrial rents have contributed to concerns about rising business costs in Singapore. In this article, we focus on rents for retail spaces.
High rents undermine the profitability of retailers, who are an important source of employment in Singapore. They also reduce the competitiveness of Singapore’s retail sector while diminishing their capacity for investment, impeding the long-term development of the retail sector.
The rise in retail rents may be attributed to two main factors: the increase in retail sales driven by an overheating retail sector; and the institutionalisation of ownership and management of retail space through private developers, property funds and Real Estate Investment Trusts (REITs). We examine each of these factors in turn below.
Overheating Retail Sector
During the period 2000-2012, it is likely that high economic growth and the influx of foreign workers which kept labour costs low raised the expectations that businesses had of their returns. This led to escalating bids for retail and food and beverage spaces, which allowed landlords to charge higher shares of incomes as rents.
Based on data from 2000-2015, strong correlations (>0.75) can be observed between the growth in the Singapore population and the shop rental index. Positive correlations (>0.4) of growth in visitor arrivals and growth in the retail sales index, and growth in the shop rental index were found. Rising rents was one of the mechanisms through which an overheating economy led to higher consumer price inflation.
Source: Department of Statistics Singapore via CEIC
This raises a question that merits further study: whether policy settings in the post-SARS period after 2003 had been set to achieve too high a pace of growth which then led to overheating and high costs.
The impact of REITs
Another contributor to rising rents could be the institutionalisation of ownership of retail space. Since the first listing of the CapitaLand Mall Trust listing in 2002, real estate investment trusts, better known as REITs, in Singapore have grown. As of September 2014, there were more than 33 REITs representing a total market capitalisation exceeding S$61 billion, with the REITs holding retail assets, office blocks, serviced apartments, hospitality, healthcare, industrial and warehousing in Singapore and abroad.
Contribution of REITs to rising rents
The question of whether REITs have contributed to rising rents has been explored by various parties in Singapore, including IPS.
The evidence though, is mixed. An MTI study showed that the higher levels and growth rates of rents observed in REIT-owned malls appears to be largely driven by the better physical characteristics of the REIT-owned malls. After controlling for observable mall characteristics like Asset Enhancement Initiatives (AEIs) and distance to the nearest MRT station, the level of rents in REIT-owned malls is not statistically different from that in single-owner malls. However, Associate Professor Sing Tien Foo from the National University of Singapore finds that real estate rentals in all sectors significantly increased in the REIT era (1Q2003) after controlling for macroeconomic and real estate market factors.
Using the growth in gross revenue per square foot of net lettable area (NLA) as an indicator to estimate rental increases in REIT-owned properties, it is seen that rentals in three malls in CapitaLand Mall Trust’s portfolio —Junction 8, Tampines Mall, and Funan Digitalife Mall — have grown by 82.23%, 64.98% and 46.93% respectively over the period 2003-2013, outpacing growth in the shop rental index at 36.02%.
CapitaLand Mall Trust’s overall portfolio gross rental income per NLA increased 112.67% as compared to the index at 34.83% over the period 2003-2013. The gross revenue per net lettable area of VivoCity, owned by Mapletree Commercial Trust, rose by 57.56% from 2010/2011 to 2014/2015.
Source: Urban Development Authority via Realis, Capitaland Mall Trust Report to Unitholders, Annual Reports
The landlord or REIT owner adds substantial value to retail space. For instance, they can carry out improvements to the look and layout of the building, ensure that the property is well-managed and that there is an optimal tenant mix, and provide advertising and promotion support to attract customers. The customer traffic or footfall that each store attracts leads to inter-store externalities for other stores near it and has an impact on their profit margins. REITs maximise this through an optimal tenant mix and through agreements where they could potentially receive a cut from the tenant’s revenue.
Do REITs tilt the playing field unfairly against tenants?
The main concern among retailers is the imbalance of bargaining power between themselves and REITs, which has contributed to an escalation of rents and costs passed on to the consumer. This is reflected in the profitability differentials between REITs and retailers: REITs may have net income to gross revenue ratios of 30-50%, while retailers and F&B outlets have operating surpluses of 4-6%, with rental costs being the fastest growing cost component among F&B services at 10.0% from 2012-2014.
This is due to several factors, including structural factors such as the supply and demand imbalance of retail space in Singapore, differentials in barriers to entry, and the lack of a true suburban retail market. There are also market imperfections such as the allegedly high market concentration of REITs, local monopoly effects which reduces the substitutability of retail space, as well as tenant switching costs.
There is no conclusive evidence of anti-competitive behaviour by REITs. But given the structural advantages accruing to the landlord, it is necessary to develop a more robust tenant protection framework to level the playing field for tenants. For example, tenants lack bargaining power when it comes to negotiating rentals with large landlords. This is due to three reasons.
Market Concentration
Source: Urbis, CapitaLand Mall Trust Annual Report 2014
It could be argued that an oligopolistic market structure has contributed to stronger pricing power for REITs. Based on IPS estimates however, market concentration in the sector in 2014 remains relatively low. The aggregated market shares of the four and eight largest companies given in the table above is 30.6% and 43.6% respectively. However, the ratio of the market share of the largest company (CapitaLand Mall Trust) to the second largest company (Pramerica) is 2.55, while the largest firm takes up 46.7% of the market share of the four largest firms.
The low vacancy rates in malls owned by CapitaLand Mall Trust as well as the strong property demand suggest that demand and supply imbalances, rather than strategic price-setting among REITs, remains the main cause of rising rents.
Rent prices have not been set at above-market-clearing prices while occupancy rates are greater than 99% for the majority of CapitaLand Mall Trust malls over the period from 2006 to 2014. Nevertheless, the outperformance of the largest landlords suggests that market structure and pricing power could well influence business costs even if regulatory thresholds are not crossed.
Local Monopoly Effects
Convenience is king. Landlords who own all retail space that serves a given population catchment area may be able to charge higher rents due to the low substitutability of prime retail space. To prevent natural monopoly effects, retail space within a given catchment area (such as malls beside an MRT/Bus Interchange) should not be owned by a single landlord to ensure adequate competition.
In addition, the bid process during Government Land Sales (GLS) may result in market distortions in cases where the landlord owns an adjacent plot. For example, Frasers Centrepoint, which owns Northpoint Shopping Centre, made a bid in the GLS auction for a mixed commercial and residential site adjacent to Northpoint. Their bid was 47.4% higher than the next highest bid, which may reflect a monopoly premium, the costs of which will be borne by future tenants and consumers. Analysts note that this reflects the synergies of the two malls and “the determination to protect its market position in the Yishun area”.
Tenant Switching Costs
The presence of high switching costs for the tenant increases the bargaining power of landlords during lease renewal negotiations. Switching costs generally result when retailers have invested heavily in a fit-out and stocked shop for the term of the lease as well as building up a customer base at its retail location. Tenants who change locations incur the cost of refitting new shops. These considerations could make tenants more willing to pay higher rents during negotiations than they would in a perfectly competitive market.
Professors Joseph Farrell and Paul Klemperer, in a paper entitled Coordination and Lock-In: Competition with switching costs and network effects, published in 2007, noted that the presence of switching costs for tenants may incentivise vendors to institute rules that reduce the viability of alternatives for tenants. For instance, this may be through clauses in the agreement that hinder customers from terminating contracts even when the agreement is no longer beneficial to them. This creates a lock-in effect which gives vendors lucrative ex-post market power. Examples of this in retail include landlords offering low starting rents followed by high rent step-ups, retrofits which are billed to tenants, and severe penalties for early termination of the lease contract.
Recommendations
In general, there are two broad ways to justify government intervention in markets. Firstly, to correct market inefficiency or mispricing, and secondly, to ensure equity. We have provided a very brief assessment of potential sources of market inefficiency which could potentially arise due to imperfect market conditions.
Acknowledging the influence that landlords and REIT owners have over the profit outcomes of their retail tenants, the Rental Practices Working Group (RPWG) of the Singapore Business Federation-led SME Committee (SMEC) developed a Fair Tenancy Framework for Business Premises, launched in 2015. This is a set of leasing guidelines and negotiation principles for small businesses looking to rent premises for commercial, industrial, retail and food and beverage activities. It aims to help landlords and tenants better understand their roles and responsibilities, and provide a framework for resolving disputes that may arise between both parties.
The following are some suggestions to extend the existing framework:
- Effective rents should be made publicly available for potential-buyers/leasers to check and make more prudent decisions. This information can be managed by a third-party independent of the landlords and tenants for greater visibility. Tenants are encouraged to check the rents via this information bank before signing any tenancy agreements.
- Introducing a set of rules for landlords and tenants, including cost-sharing for retrofits, longer notice periods for tenants when they no longer have the option for renewal, and restricting the use of certain clauses such as the exclusivity and non-compete clause for tenants within a nearby location.
- Setting up a tenant protection agency to assist tenants in the process of reviewing contracts, as well as to facilitate collective bargaining by smaller tenants when negotiating with major landlords.
- The prevention of local monopoly effects by blocking entry in Government Land Sales (GLSs) by the incumbent that owns adjacent plots of land parcels, and dividing land parcels in GLS within a given catchment area so that incumbents are not permitted to obtain all the lots, has been suggested.
In addition, the last few years have shown that a policy emphasis purely on efficiency grounds is unsustainable in the light of changing demands and concerns of the citizenry towards outcomes oriented towards equity and diversity.
One of the ways to address this is the provision of publicly owned and managed retail spaces. The number of shops managed by HDB has fallen in recent years, from 30,473 in 1990 to 28,477 in 2014. One recommendation would be to increase the supply of publicly managed retail spaces such as wet markets, hawker centres, and grocery and provision shops, and basic services and to regulate the tenants of these spaces, to provide insulation from rising costs for the lower income groups.
Manu Bhaskaran is an Adjunct Senior Research Fellow and Ng Yan Hao is a Research Assistant at IPS. Their work focuses on the causes and impacts of rising business costs in Singapore.
Top photo from thinkstock