The UK industrial sector has bucked the trend seen in the other major commercial property sectors since the Brexit vote in June last year. Intense investor demand and high levels of investment activity have driven down yields on prime assets to record lows. So can investors still find value in the sector, or is it already too late in the cycle? How can they capitalise on future growth opportunities without taking on too much additional risk?
A record £6 billion was invested in UK industrial property last year, with a further £3.5 billion in the first half of 2017. As a result, prime industrial yields have fallen by around 0.25%, with the lowest in London and the South East now being quoted at 4.5% for standard industrials. Whereas only a year ago, there was a 1.25% to 1.5% premium for prime industrial yields over prime office yields, that gap has now fallen to 0.75% and only 0.5% over prime high street shops.
But this does not reflect the reality of actual yields being transacted in the marketplace and the considerable differences in yield levels for the many segments of the market, which creates opportunities for investors to still find value opportunities.
Smaller lot sizes = greater value
For instance, historically yields on smaller lot sizes (<£10 million) have been 1.0% higher than those of larger lots (>£10m), but the focus of institutional investors and REITs has been almost exclusively on larger lots. Smaller lot sizes therefore trade at a discount because of the lower weight of capital targeting them. Of a total of 667 industrial investment deals involving lot sizes greater than £5 million between the beginning of 2015 and August 2017, 60 percent were greater than £10 million, according to Property Data, with the average lot size at £25 million. At the other end of the scale, only four percent were of lot sizes greater than £100 million.
The average yield on all those deals was 6.5%, with almost 90 percent traded at yields at or higher than 5.5% and only five percent at or below 4.5%. With the average yield on transactions of less than £10 million at 7.0% compared to 6.0% for those between £10-50 million, smaller lot sizes continue to command an illiquidity premium. This also reflects the fact that they are generally more management intensive, with lower gross-to-net operating income ratios than larger lot sizes, so all these factors must be taken into consideration.
Distribution of industrials investment deals by yield (2015 to YTD 2017)
Source: Property Data & Canada Life Investments research. Includes all transactions >£5m.
Finding value in shorter-term income
Similarly, there is a yield premium on shorter term income, as institutional investors and pension funds have traditionally focused on the longer-term, in the search for greater security and higher tenant covenant strength. Although yields for all income profiles have been falling consistently since their peak in 2009, there is still a yield gap of around 1.5% between short-term (under seven years) and long-term (more than 15 years) and around 0.8% to 1.0% between medium-term and long-term income.
This gap is now falling rapidly, however, as shown in the chart below. In the first half of this year, yields actually compressed at a faster rate on short-term income compared to long-term income as the concept of ‘optionality’ and increasing value through active asset management attracted more investors to target assets with tenants on shorter leases. This is a trend which we expect to continue.
UK industrial sector yields by remaining lease term
Source: MSCI/IPD UK Quarterly Index, Q2 2017.
Unlocking value via refurbishment potential
The yield gap between good secondary and prime industrial assets is currently around 1.25%. Yet there is still a chronic shortage of investable grade A stock, despite a recent increase in speculative development. Property agent Cushman & Wakefield reports that the grade A portion of national available space dropped by 23% during the last quarter of 2016 and by a further 3.3% during the first three months of 2017, despite over seven million square feet of speculative space completing during 2016. Of the more than 121 million square feet of available industrial and logistics space across all UK sub-markets, only 9% of available space is grade A.
After a strong year of leasing activity in 2016, the first quarter of 2017 saw five million square feet being taken up, on a par with Q1 2016. Take-up of newly completed properties accounted for sixty-four percent of total demand, as occupiers who have been unable to find suitable space, are increasingly seeking purpose-built solutions.
As demand continues to outstrip available supply, a value-add strategy of investing in grade B properties close to strategic urban centres to refurbish and upgrade to grade A standard last-mile delivery centres or warehousing facilities, looks appealing. Agent Gerald Eve reports that almost 1.5 million square feet of recently refurbished space was taken up by occupiers in the first quarter of this year alone.
Technology & e-commerce the future growth drivers
But what is the outlook for the occupier market? One of the most compelling reasons to invest in it over the last few years has been the prospect of being involved in a dynamic sector which is still evolving as a result of major ongoing structural change due to the growth in e-commerce. Against a challenging current economic environment in which consumer spending is being squeezed and macroeconomic risks are increasing as a result of Brexit uncertainty and rising inflation increasing input costs, the occupier market fundamentals have remained relatively resilient.
While the weak pound is benefitting export-led manufacturers, growth in the industrial sector is mainly being driven by major online retailers such as Amazon, as well as multi-channel /department store retailers such as John Lewis, fashion retailers such as Next and New Look, the discount supermarket operators such as Lidl and Aldi and the automotive sector. These operators are investing heavily in technology and automation to increase the speed and efficiency of their online delivery operations and supply chains to cater for faster next, and even same day delivery services. As well as looking for larger distribution warehousing sheds, they are also targeting smaller sheds either for urban logistics facilities in order to service last-mile delivery for customers, or for those in the manufacturing supply chain.
Since growth in online shopping is expected to account for approximately 20 percent of all UK retail sales by 2020, from around 14 percent today, e-commerce expansion will increasingly drive the occupier market for the foreseeable future. Therefore, although industrial take-up this year is expected to be down by around ten percent overall on 2016’s record-breaking year, the level of speculative completions is also expected to be around half the volume completed last year, while a significant amount of industrial space close to urban areas has been taken out as it is being converted to higher value residential use.
Consequently, the prospects for rental growth in the sector are therefore stronger than the office and retail sectors, with standard industrials in London and the South East expected to see the strongest forecasts of around 2.5% to 3.0% per year over the next five years, compared to 1.3% to 2.0% for industrials in the rest of the UK.
Look beyond the core to find value
Finding value in a market with a scarcity of assets, a highly competitive investor market and record low prime yields has clearly become a challenge. But it can still be found for those investors prepared to move slightly up the risk curve to target core-plus and value add strategies, as well as investing in higher yielding good secondary assets in strategic locations. The positive outlook for the sector is expected to lead to attractive risk-adjusted returns for all industrial segments despite the more uncertain, subdued economic outlook.
The value of investments may fall as well as rise and investors may not get back the amount invested.
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