The urban warehouse market has a number of characteristics that make it highly attractive for asset owners, such as Warehouse REIT.
Strong occupier demand
Urban warehouses are in high demand from potential tenants. They are used by a wide range of occupiers, from small industrial and manufacturing businesses to major retail chains and distributors. The robust UK economy, with record levels of employment, means that many businesses are competing for this space.
At the same time, urban warehouses have become an increasingly important part of the UK logistics delivery chain, creating a powerful extra source of demand for space. They are now critical assets for companies looking to fulfil e-commerce orders quickly and efficiently. This has made internet companies and their service providers among the biggest takers of warehouse space in the UK, helping to push up rents for all industrial tenants.
Further rapid growth in e-commerce is expected over the next few years and this phenomenon is not limited to pure online businesses. Most companies now need a digital strategy and this is allowing, for example, manufacturers to sell directly to the public from their warehouses, further disintermediating the retail high street.
Demand for space is spread around the country and is particularly strong in key logistics centres such as the Midlands. This allows asset owners to spread risk by building up portfolios which are geographically diverse, yet still benefitting from strong occupational demand which is not solely focused on the South East.
Demand for small and medium-sized warehouses (less than 50,000 sq ft) is strong, with take-up increasing by 5% in 2017 compared with the previous year. In contrast, demand for logistics space (over 100,000 sq ft) fell by 19% in 2017. In total, small and medium-sized warehouses accounted for 55% of total take-up in 2017.
The supply of industrial space has not grown sufficiently to meet the rise in demand described above, resulting in availability rates more than halving over recent years. According to Lambert Smith Hampton (“LSH”), UK-wide supply reached a new low of 156 million sq ft at the end of 2017, with a further fall in availability in all size bands during the year.
LSH research shows the sub-50,000 sq ft segment has the lowest level of grade A availability and in total, small and medium-sized warehouses have just 1.6 years of supply.
The supply of urban warehouse space is unlikely to increase rapidly in the short to medium term. Smaller assets are pro-rata, more expensive to build than Big Boxes and the high build cost makes development uneconomical. This is demonstrated by the capital value of our portfolio, which is well below the rebuild cost.
We estimate that passing rents would need to increase by around 25% before development becomes viable in most markets.
The shortage of supply also means that tenants are increasingly requesting longer leases and accepting reduced incentive packages.
Falling vacancy and rising rents
The supply and demand dynamic in the industrial real estate market has contributed to sharp falls in vacancy rates and corresponding rise in average rents, as shown in the chart below.
Given the expected growth in e-commerce and the demand for ever-shorter delivery times, combined with a strong manufacturing sector, we believe the upward pressure on rents will continue. Market forecasts support this, with industrial rental growth to 2022 predicted to be well ahead of other sectors of the real estate market, as shown in the chart below.
The investment market for industrial assets
The highly attractive fundamentals of the occupier market mean there is strong investment demand for industrial assets. According to LSH, 2017 was a record year for transactions, with £7.5 billion of industrial assets changing hands. This was a 44% increase on 2016 and above the previous high of £6.7 billion in 2014.
The industrial sector was the best performing real estate sector in 2017, with a total return of 19.6% against an All Property return of 10.2% (source: LSH). Total returns from the sector are forecast to remain strong and ahead of the wider market over the coming years.
Transaction yields at the prime end have compressed. However, we continue to see opportunities for Warehouse REIT to acquire assets at attractive prices and have demonstrated our ability to source.