Co-operation or Extinction? Retailers, landlords and the Prisoner's Dilemma
"If the retail sector is ever to be investable again, it has to be given the chance to grow." - Mark Burlton, Cross Border Retail
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My family are often shocked by the deeply inappropriate metaphors I sometimes draw from history to describe real world problems. Natural disasters, wartime events. But it would be quite a job to ransack the arena of human history to find a metaphor distasteful enough to describe what's about to happen in retail.
'Ticking time bomb' has already become a cliche (and in any case, that 'bomb' exploded at the start of the pandemic). What we are seeing now are the foreshocks of a major earthquake which will reshape the retail landscape forever. And the faultline about to slip is between retail landlords and tenants.
Tensions between physical retail and landlords have been building for years. On one side are retailers who are on the front line of huge societal changes driven by technology and the relentless march of the Internet.
On the other side are landlords - sometimes small players with a retail property providing a nest egg, but more often than not huge (sometimes shadowy) organisations who represent powerful vested local interests with fingers in many pies.
(Up until recently, you could add local authorities and a broken business rates system in with landlords, but COVID-19 has essentially shut down this asymmetrical tax. However, it's still there, furloughed, ready to spin up again like a distant buzzsaw when we get 'back to normal')
But normal seems a long way away. And today (June 24th) things are about to get a whole lot more 'not normal'. For today is "Quarter Day".
When I started in retail, I had zero experience, so it was a bit of a shock to be pitched into the archaic, Dickensian world of retail property. Still conducted in frock-coated, hushed lawyer offices, using archaic language and a plethora of impenetrable vocabulary (side letters? covenants?) taking on a retail lease is like stepping back 100 years and it's replete with every kinds of structural inequality you care to mention.
It's like the Internet never happened. Actually, scratch that. It's like John Logie Baird - no, Marconi! - never happened. In business accounting, leases are still considered to be an asset (as if retail space is still a rare commodity that cannot be expanded) and - already starting from a high level - landlords can blithely - and legally - build in rent rises. This is courtesy of a delicious piece of dastardly legislation dating from 1954 known as 'upward-only rent review clauses'.
And Quarter Day is one of four days in the year when the rent collector comes knocking.
It's as if retail rents are a law of physics, and not (as they actually are) a convention totally divorced from any business reality.
Well reality is about to assert itself in a very unpleasant way.
Landlords are crying foul and bringing the lawyers in. Retailers - most of whom are on their knees financially - are also crying foul and refusing to pay. It's a classic power struggle, and whatever metaphor you care to use at this point ('economic Mexican stand-off' springs to mind) the result will be the threat of mutually-assured destruction, tossing a big can of petrol onto the roaring fire that is Retail Armegeddon.
So how do we pull back from the brink?
First of all, we need to calm down with the rhetoric (me included) and instead look at solutions that are already lying about.
And a great way to start this process is to examine the struggle between landlords and tenants through the lens of Game Theory, specifically The Prisoner's Dilemma.
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The Prisoner's Dilemma is probably the classic problem studied in the field of Game Theory. At the risk of having you switch off here, Game Theory is a branch of mathematics, but it extends maths firmly into the realm of human behaviour.
In the classic Prisoner's Dilemma, two criminals have been apprehended, and placed in different prison cells. They are definitely guilty (no trumped-up changes here) but neither is talking. Also, they know the evidence against them is weak, and the police do too. If they can both just keep their mouths shut and call the police's bluff, they will walk.
But they can't communicate. I mean, each of them might assume the other will keep quiet but they can't know that for sure.
The police have all the power here, and want they get them to sweat and start blabbing. So they offer each prisoner a deal.
The police inspector is very sympathetic as she turns the chair around and sits down in front of Prisoner A. Bad choices have been made, she understands, but justice must seen to be done. However, she's keen to offer a deal.
If Prisoner A grasses up the other criminal, they will get a reduced sentence (say one year, probably out early for good behaviour).
But if they keep silent (and here's the crucial part) and the other prisoner grasses them up, then the police will push for the maximum sentence: five years hard labour. Gulp!
The same deal of course is offered to the other prisoner.
"Ah, but what if I blab and the other prisoner also blabs?" asks Prisoner A.
"No problem" says the police inspector, "we'll split the difference and round down. So if you both implicate each other, you'll each get two years."
The easiest way to understand this is something called a 'payoff matrix' and - choosing two names for reasons that will become clear shortly - let's imagine we have two individuals Mark and Kantu.
Without going into the theory too deeply, one thing should be really obvious: the best thing they can do is keep quiet. No question.
But they can't communicate. They can't be certain what the other will do. Perhaps Mark knows that Kantu nurses a grudge, and he worries he won't keep quiet. So the logical thing - in the absence of any communication - for each prisoner to do is blab. The worst that will happen is 2 years. The risk of getting 5 years is just too high a price - and too risky.
And this is the resolution to the Prisoner's Dilemma. In the absence of any communication, both prisoner's will choose to blab, and the optimal scenario is never reached. This is known in maths as a Nash Equilibrium (after John Nash, made famous by the film A Beautiful Mind).
So how does this work in the world of retail.
We have to get a bit imaginative with the scenario, so let's fill in some blanks.
We're going to take a real-world retailer - Primark - who have a great deal of power in the retail world. They have been withholding rent from some landlords, paying other - and getting those landlords to sign gagging orders to prevent anyone knowing who's paid who. Cunning huh?
We'll also take a real-world landlord - Intu - who own some of the UK's most iconic retail parks. Before COVID-19 they had already run up £4.5bn in debt (!) and are in danger of going bust (we'll find out tomorrow) if widespread non-payment occurs. I assume that Primark feature somewhere on their list of tenants.
And the police? They are the reality police.
Just as real-world prisoners end up having their collar felt through a series of bad choices, Intu and Primark are sitting in the 'reality dock' as a result of some very bad choices. Both have committed heinous crimes against reality.
In Primark's case, they have - deliberately and strategically - avoided any online presence or ability to trade on the Internet. Which means they crashed when COVID hit. Shocking, huh? And that's before we get into any the ethics of how they make their clothes.
Intu have engaged in extreme can-kicking, continuing to run their business whilst cocking a snook at reality by running up unsustainable debt whilst paying themselves large bonuses and salaries.
The Reality Police are not happy. But they are prepared to offer them a deal.
Both could harden their positions against the other. They might get - or save - themselves some money, but if the other side hardens their stance, the lawyers might get involved and this could messy (and expensive).
Like the prisoners, the best scenario is for both sides to start negotiating. But individually - with no ability to know what the other might do - it's difficult to see that happening. The Nash Equilibrium dictates that logically, for each other, there will be a hardening of each other's stance.
And whilst those of us on the retailer side might cheer the sight of a nasty landlord getting their comeuppance, there will inevitably by US-based VC companies sniffing around for a juicy bargain, and - believe me - these people make the current crop of landlords look like pussycats.
The stakes for failure is an acceleration in the vicious circle of physical retail decline. Negotiating has big wins for everyone. Unfortunately, here's what the payoff matrix looks like:
This is an insultingly simple analysis (and I can hear mathematicians weeping) but in the absence of any meaningful communication (and more critically, trust) the logical thing for each to do is harden their stance.
So how does the Prisoner's Dilemma get resolved?
In a word: co-operation. So important (and common) is co-operation in the natural world, that it's even been held up as a central tenet of evolution itself.
But time is short, and trust is low. So what can be done?
The best summary I've read comes from Mark Burlton of Cross Border Retail. He outlines the following measures:
- Remove the archaic upward-only rent review clause
- Fix business rates
- Allow rent payments to be tied to turnover percentages with some online component factored in
This would require unprecedented co-operation between landlords and retailers. It would require audited store performance (and of course, auditors haven't exactly covered themselves in glory in recent years) but all of this is possible.
And if there is one word that defines 2020, it's 'unprecedented'.
Co-operation in the natural world exists because of the need not just to survive, but grow. And - remembering that much retail property is invested in by your pension - Mark makes this important point: "If the retail sector is ever to be investable again, it has to be given the chance to grow."
Retail analyst Natalie Berg reluctantly admitted on a recent episode of the BBC's Business Matters that small retailers are facing an extinction-level event (at least in the United States). What is needed now is an effort by everyone - retailers, landlords, government - to take this opportunity to re-wire how retail works.
We may not be able to save every retailer. Bad choices cannot be undone, and the reality police need justice to be served. But we can provide the best possible chance that good choices to be made in the future. It's time to rehabilitate retail - and save it.
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