TOPIC OF THE MONTH

The Industrial And Logistics Sector

STEPHEN DONE | INVESTMENT RESEARCH

In recent years, the industrial and logistics sector in the UK has been growing in importance and gaining increasing popularity among real estate investors. Following Brexit and the pandemic, the extent to which logistics is a critical element of the UK’s infrastructure which underpins the UK’s economic output became increasingly apparent. Ranging from highly automated large-scale fulfilment centres to small urban or lastjourney warehouses, these distribution assets continue to underpin the UK’s economic output by playing an integral role in safeguarding the integrity of supply chains and supporting business functionalities. However, the modern logistics market is still in its relative infancy, with multiple powerful and long-term structural trends underpinning demand for these assets.

A main driver for demand in these assets is related to consumers’ growing demand for flexibility, accessibility, and convenience in retail shopping. This, combined with the decline in the high street and retail footfall, has led to a continued rise in e-commerce in recent years, with online sales accounting for 27% of total retail sales in the first half of 2022. To fulfil this demand, businesses are having to develop extensive and increasingly complex supply chains, in which logistics real estate plays a fundamental role. Online retail supply chains require more warehouse space than traditional high-street models, with logistical assets playing a crucial role in storing, transporting and delivering online deliveries. Research from Knight Frank and UKWA suggests that every £1bn of additional online sales typically generates between 0.8m and 1.4m sq ft of demand for new logistics property.

Current economic conditions, with high inflation and pressures on consumer finances, are resulting in increased pressure on company margins with the need to not only grow revenue and expand market share, but to optimise supply chains with a focus on resilience, efficiency, and a reduction of costs. With warehouse rents making up a small share of total costs, the consolidation of smaller disparate or retail units into a larger distribution centre will not only offer economies of scale but the ability to optimise staffing and stock levels. This results in the best-located units, which are close to the consumer and in dense urban markets, becoming more important, with such sites offering higher efficiency while also helping to mitigate rising costs associated with labour and transportation.

There is currently a worldwide drive to enhance sustainability performance, with government targets and regulations ensuring the transition of the UK towards net zero by 2050. Consumers are becoming increasingly conscious of the environmental impact of goods they purchase, with organisations under pressure to actively seek warehouses that meet environmental criteria. These modern assets feature enhanced insulation, LED lighting and large roof spaces this supply chain disruption have led to some businesses looking to nearshore manufacturing closer to the point of retail. Manufacturers are also under pressure to resolve ESG concerns regarding globalised supply chains, with current production in economies that have lower worker and environmental protections; both factors continue to drive demand for logistical space within the UK. capable of accommodating solar panels. Grade A buildings are currently the most attractive for occupiers, as they will not require refurbishment to meet the anticipated future regulatory requirements, such as the minimum rating of B for Energy Performance Certificates. Occupiers will place a greater weight on meeting these higher Environmental Social & Governance (ESG) standards that can save costs and reduce the carbon output of warehouse operations.

Despite this strong demand, the supply of these prime, large-scale logistical centres remains constrained. The key component to constructing these assets is the location, with limited land able to accommodate these large buildings, and becoming even more scarce in key locations. ‘Big Boxes’ also require a large local labour pool, with some assets employing more than 3,500 people during peak times. The large scale of these assets requires significant planning permissions, with many requiring rearrangements to traffic routes and, therefore, taking years to obtain the required consents.

Another challenging factor relating to the location of these assets is the availability of and access to power. The supply of energy to sites via the national grid is finite, however, occupiers need to obtain substantial power to meet the future growth of automation and the advancement of electrical transportation. Developers are alive to the issues, with many schemes offering alternative renewable energy provisions and power-saving initiatives to occupiers looking to futureproof their business, with these trends expected to continue through the next few years.

The tight monetary policy experienced in the UK has led to rising interest rates driving up borrowing costs, and inadvertently driving up the ‘all in’ costs of finance for developments. This has also affected the purchasing ability of leveraged buyers, leading to a reduction in the number of speculative builds following the increased risks.

Supply chains have been the lifelines of globalisation, delivering lower costs and greater efficiencies to the manufacturing sector over previous decades. However, the pandemic, rising geopolitical tensions and a sustainability drive have exposed the limitations of the just-in-time supply model, such as supply chain disruption, and have led companies to prioritise resilience within supply chains. Resilience can be built into supply chains by shifting to a just-in-case inventory management model, which holds more stock, requiring greater warehouse space, to minimise losses if delays in supply do occur. However, concerns around

In recent years, there has been a resurgence of occupiers looking to build-to-suit developments that can meet the increasingly bespoke occupier requirements. The economic conditions have led to a reduction in speculative units due to weaker developer risk appetite, following the rising ‘all in’ cost of debt finance, increasing construction costs and higher exit yields which will further impact supply.

The constrained supply and increasing demand have led to an imbalance in the market and have resulted in the vacancy rate within the logistics sector reaching record lows of 2.9% in 2022. The continued demand above long-term averages and vacancy levels remaining critically low with a lack of speculative builds are estimated to lead to continuing rental growth. This growth rate, although expected to be moderate compared to the double-digit growth experienced through 2021 and early 2022, will lead to the logistics sector reinforcing its position as a major contributor to the UK economy, and one of the most attractive locations for favourable returns within real estate investment.

The UK office real estate market has been heavily impacted over recent years, both by the impact of COVID-19 on the dynamics of working life and by the changing economic environment for tenants and landlords pushing up the costs of borrowing, building and renting office space.

Yet, further pressures are also looking likely to increase the pressure on office stock going forward, following the minimum energy performance regulatory requirements coming into effect in the spring of 2023. With an array of potential roadblocks for property investors and management companies it is likely that we will see a transition within the office space, to adapt to trends and provide more services to remain attractive to new and retained businesses throughout the transition of ‘flight to quality’ within the office market.

Looking forward to 2023, one of the biggest potential headwinds is the Minimum Energy Efficiency Standards (MEES) regulations, which are a key part of the strategic approach of the UK government to significantly reduce carbon emissions, of which commercial property are some of the biggest emitters of CO2. Current MEES regulation has been in place since 2018 and requires buildings with new tenancies to achieve a minimum EPC rating of E before they can be let to new tenants; from April 2023 the same rule will apply to existing tenants. The issue here is that almost 10% of London’s office stock currently has an EPC rating of F or G, meaning that as of April 2023 landlords will not be able to let new leases if the property doesn’t meet the required standards. This is likely to have an impact on investors due to the capital spend needed to improve rating levels to an E or better. Further regulatory tightening is yet to be had, with new minimum requirements stating an EPC rating of B or C by 2030. However, around 80% of London’s office buildings are below this minimum standard and will need to be upgraded by 2030, an equivalent of 15m sq ft per annum.

With much of the market likely to face strong headwinds over the next seven years, A grade office space looks to be well positioned within the market going forward. Following a focus in ‘flight to quality’ buildings over recent years, premium office space has become some of the most soughtafter property across the UK. Much of the demand comes as a result of high-quality, tailored fit-outs, allowing companies to lease space that aligns with company culture and provides an attractive, modern and exciting place to work, while promoting collectivism through group work areas. A further selling point are the additional services provided, such as concierge, security, corporate discounts to businesses within the surrounding areas, and other benefits. Finally, properties that hold strong EPC ratings, which A grade offices do, are likely to yield lower energy bills, a smaller need for renovations and thus less disruption to tenants, longer lease life for tenants as they remain happy with the high-quality characteristics of the property and, finally, often a greater alignment to tenants’ environmental goals in reducing their carbon emissions.

Because of this, A grade properties are able to command greater rents and tend to attract premier tenants, with limited default risk of rental payments. Further market conditions within the space suggests that due to a supply and demand imbalance, grade A properties are likely to see an uptick in prelet agreements, with 35% of space under construction being pre-let, and this is expected to increase as the year progresses.

At the other end of the spectrum, lower quality property such as Class B and C stock could possibly see a slowdown in leasing due to the poor quality and undesirable characteristics of these properties. Furthermore, depending on the EPC rating of these properties, a large amount of capital will likely have to be spent on not only improving standards of the properties, but also the attractiveness for future tenants given the competitiveness of the market. Following recent data, expectations for the average length of unoccupancy within the second-hand market is expected to increase in 2023 as demand looks weak against current supply levels for the lower quality property.

A further focus point for the year ahead from an investor standpoint will be prime yields, which is the annual return from property investments. In 2022, most UK office markets experienced an outward shift in prime yields, partly because of continued growth in prime rents drawing from the disparity within supply and demand and also from increased property upgrades allowing property managers to warrant an increase in rent due to greater quality office space. Despite positive uplifts in yields, capital values declined by 12.1% in 2022 following an unfavourable economic environment for property markets and rising borrowing costs as implemented by the Bank of England, following the rise in interest rates. Therefore, given the level of market uncertainty over 2022, it has been estimated that approximately, only 30% of total potential investments in office real estate will transact within the current market conditions, with capital investment volumes expected to be 20% down year-on-year in 2023. If we are to see a recovery within the commercial office space in 2023, it is likely that we will also need to see interest rates reduce with inflation, office upgrades and increased EPC quality, continued demand for high quality stock and improved investor sentiment in order to see valuations increase and market growth to push forward.

Historically, office real estate has been an attractive opportunity for strategic investors to diversify a portfolio and capture healthy returns from their strong underlying fundamentals and long-term lease agreements. But, with valuations falling off considerably last year, it will be interesting to see how the office space fares over the next year, particularly in terms of yield movements, property valuations, and investor sentiment. If the UK economic environment settles and interest rates look to turn the other way, it could be quite possible to see a recovery across the industry as confidence levels rise, property prices gain stability and investment volumes return more positively.