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The industrial sector makes up a relatively small, but growing, part of the UK’s commercial property market. Investors are increasingly focused on efficient supply chains and the requirements of online retailing, writes Tom Goodwin.
Real estate investors seeking exposure to the consumer economy were once restricted to the retail sector, but can now gain exposure to this important driver of the UK economy via investment in industrial property. Large national or regional distribution centres form the backbone of retail supply chains, while smaller, multi-let industrial estates, once dominated by the manufacturing sector, are of increasing importance to local or ‘last-mile’ delivery functions.
Investors in the sector are attracted by security of income, often enjoying long lease terms and strong covenants. In comparison to the retail sector, depreciation and obsolescence are of less concern. Land value, rather than the material fabric of a building, is of greater significance to an asset’s value. Non-recoverable costs are typically lower than in other sectors, with office buildings and shopping centres requiring security, mechanical and electrical maintenance, and regular refurbishment to retain their appeal to occupiers, for example.
The potential upside from conversion to alternative use is also greatest in the industrial sector. This is particularly significant in London, where industrial estates have seen large capital value gains driven by the strength of the housing market. As sites have been converted from industrial to residential use, those that remain have benefitted from increased competition among occupiers.
We consider industrial property considerably more futureproof than large parts of the UK’s office or retail sectors, where large swathes of the built stock are already obsolete. There are strong reasons to expect further upheaval – not least driven by continued growth in online retailing, and the likelihood of automation replacing some low value-added office functions. The industrial sector is certainly seeing widespread changes in the way occupiers use their space, and there is scope for significant efficiency improvements, which could mean occupiers require less space overall. However, the impact of any consolidation would be gradual, and is more likely to moderate demand growth than to cause a contraction. Warehouses are, primarily, space to store goods. It seems unlikely the need for such space will fall away.
The industrial market has seen a strong recovery in rents since the 2008-09 downturn with growth in recent years surpassing levels typically seen historically. The post-global financial crisis years have been characterised by relatively robust occupier demand and an increasingly constrained supply of newly-built stock, with development activity, particularly of multi-let estates and smaller units (sub-100,000 sq ft), at very low levels.
The reasons for the dearth of development are not entirely clear: in the years following the crash, development was constrained by a lack of finance and low risk appetite. More recently, it is possible that planning constraints have held back supply, with alternative uses creating more employment or greater development value (e.g. residential). This could provide on-going support to rental levels.
Following two to three years of strong performance, rental growth peaked in 2015 and has slowed slightly over the past year. The fallout from the UK’s referendum on EU membership has had significantly less impact in this sector than other parts of the market, with no noticeable change in market conditions since the middle of 2016. There are two reasons the sector has held up well since the Brexit vote. Sterling’s devaluation has made UK-manufactured goods more competitive; both to overseas buyers and in the UK relative to imports. In addition, consumption drives the logistics sector through online retailing. Consumer spending has, to date, been very resilient.
Indeed, we think the sector is best placed to weather the uncertain economic outlook and our five-year average rental growth forecasts, at 1.0-1.5 per cent per annum, are broadly unchanged from our pre-Brexit view. We anticipate a moderate slowdown in growth as the recovery previously underway matures, but we do not expect to see rental decline, in contrast to other parts of the market. That outlook is attractive to investors, and so the outward yield shift that we anticipate in the industrial sector is lower than in others.
According to our current forecasts, investors can expect to see total returns averaging circa six per cent per annum over a five-year period – ahead of the 4.5 per cent per annum we expect to see at an All Property level.
Figure 1: Aviva Investors Rental Growth forecasts 2017-21 % p.a.
Source: Aviva Investors February 2017. There is no guarantee forecast performance can be achieved.
The total returns we are forecasting in the industrial sector look attractive relative to other parts of the market, but appear even more so when looking at risk-adjusted returns.
At current valuations, the sector looks fairly priced relative to the hurdle rates that we use to underwrite direct real estate investments. In some parts of the market, our five-year industrial returns forecasts are more than 15 per cent above these rates. Outside of industrials, very few parts of the UK real estate market look attractive on this basis.
Among other factors, the low volatility that industrial property performance has seen historically means that we have a lower hurdle rate than sectors that are typically more volatile, such as London offices.
Careful property selection
There remain a number of risks when investing in the sector, however. On the structural side, it should be recognised that occupiers’ requirements are changing. Factors such as power availability and reinforced floors capable of supporting machinery have become as important as occupiers’ long-standing demands for access to markets and labour. Consequently, assets that lack the capacity to cope with these shifts have suffered from a degree of obsolescence.
As logistics has overtaken manufacturing as the key function of industrial property, there has been a corresponding polarisation in the attractiveness of locations, which continues to grow.
As mentioned previously, the sector’s market cycle is relatively well advanced, and has been characterised by unusually low levels of development. There is, however, a growing pipeline of larger units underway. While some of these are pre-let, many are not. Given pent-up demand following a number of years of low supply, this should not cause rental levels to decline, but it will give occupiers a greater choice of available properties, again highlighting the need to be invested in the right product. Supply of smaller units remains very tight, so selective development activity in the right locations could provide attractive returns in the current climate.
A second cyclical risk, related to the investment market rather than the occupier market cycle, is the current popularity of the sector amongst investors. Even over the latter half of 2016 as other sectors weakened, industrial pricing became quite stretched versus valuations.
Bidding on good industrial assets is therefore likely to become very competitive this year, and success will be to a large extent driven by investors’ ability to source and structure deals.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 07 March 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.