U.K. industrial property: too hot or just right?
Many investors are getting worried that the industrial real estate market in the United Kingdom is now too expensive. But does the evidence back up their fears?
Industrial is the hottest sector in U.K. real estate. 2017 was a record-breaking year: a record year of transaction volumes, a record share of all property deals and a record share of overseas investment.
Total returns were 20 percent — almost 11 percent more than the IPD All Property index average — and rising to 26 percent for London multi-let estates.
This has polarized property performance. The 17 percent appreciation in values since the EU referendum compares with 0 percent for offices and –2 percent from retail. Almost all value growth has been from the industrial sector.
Yield compression drove much of this. Yield impact was 10 percent in 2017 compared with 2.2 percent for the rest of the market as yields moved in faster. By year-end, equivalent yields were 60 basis points below the previous record low.
It has not just been a yield story. Rental values appreciated by 5.3 percent during 2017 and by more than 8 percent in London.
Investors continue to rate the sector as a strong “buy”. But this staggering performance has provoked an obvious question: Is industrial overvalued? Or could it be that market pricing is finally catching up with its compelling attributes, many of which have improved structurally?
To find out whether the sector is too hot or just right — to use a Goldilocks analogy — we need a framework to determine value.
A property sector’s yield reflects its risks and its prospects relative to both its peers and a risk-free rate. This provides us with an empirical basis to determine fair value. If there have been no meaningful changes to the sector’s attributes, yet its yield has compressed further than other sectors, we would have a basis to declare a bubble. If, however, there have been positive and enduring changes, then it may be the case that extra yield compression is justified.
This analysis sets out our views on the most important determinants of relative yield. This is based on data as at Q4 2017; the pace of change means establishing this point in time is more important than usual.
- Rental forecasts
If rental growth is expected to be better over the medium to long term than historic trend rates, and/or stronger than other segments, this would justify more rapid yield compression all else being equal.
IPF consensus forecasts for the five years to 2022 show industrial rental growth expectation of 2.3 percent p.a. versus 0.8 percent for office and 1 percent for shops. This rate is lower than recent history but relative performance would remain compelling. Longer-term forecasts from PMA show outperformance relative to the IPD All Property of 1.1 percent p.a. over the 2017–2027 period. They rate the sector as the strongest performer.
The drivers of this relative performance are structural. E-commerce is well understood, but that should not diminish its importance. It is not just the logistics segment that profits; delivery companies operating from smaller urban locations are benefitting (although competition is fierce) and throughout the sector small businesses are improving revenues by targeting online sales.
The volume of industrial stock has fallen. Figures from the U.K.’s Valuation Office Agency show that there is 5 percent less stock today than there was in 2001. This compares to growth of 13 percent in offices over the same period, for instance. In inner London, stock loss has been in excess of 30 percent. Of more relevance is the 10 percent growth in housing stock. Much of that has come at a cost to urban industrial and this competition from residential has both pushed up industrial land prices but also displaced occupiers, driving the rental values on remaining units higher.
Furthermore, as the U.K. population has grown, the ratio of industrial stock per person has fallen 14 percent. This matters because, as the population continues to grow — by a further 4 percent over the next 10 years according to Oxford Economics — remaining industrial stock will become more important and need to operate more efficiently to service needs whether it is by distributing goods, storing them or making them in the first place.
More cyclical support has been given by a return to positive net lending to the SME sector. This has been relatively recent. According to Bank of England figures, annual lending growth only turned positive in late 2015.
There is a perception that industrial depreciates more than other sectors, especially logistics. This view has been influenced by accounts of obsolescence in form and location. The IPF conducted a study in 2011 looking at rental and capital depreciation across the main U.K. property sectors and segments over the period 1993–2009. Although these numbers have dated, we see no reason to challenge the observation that industrial depreciated more slowly than the all property average and much more slowly than offices. Industrial in the southeast depreciated by even less and a portfolio weighted to this segment (which has been a feature of success in recent years) would show less deprecation than office and retail.
- Income Risk
If industrial were to be deemed overvalued, we might observe a greater level of default or generalised income risk. Using the MSCI weighted risk score, the gap between industrial and the all sector average narrowed from 10 percent in 2008 to 2 percent at the end of 2017. Furthermore, the default rate within the sector shows no meaningful difference at 2.6 percent compared to All Property’s 2.7 percent, with retail and office at 3 percent and 2.7 percent, respectively. Differentials were as much as +1.2 percent (in 2006) but the gap to All Property has not deviated much from an average of 0 percent since 2013.
If the income is no more risky than other sectors, yields would still be higher if income was shorter. Using the MSCI/IPD series for new leases (including breaks and excluding short leases) the average industrial lease signed in 2017 was 9.4 years compared to 9.6 for All Property and 9.5 and 10.6 for offices and retail respectively. This compares to a gap of 2.5 years back in 2002. Granted, much improvement may have come from longer let logistics properties but the observation that industrial leases are not notably shorter is important. In fact, industrial leases seem to be trending longer and trending shorter elsewhere.
Illiquid assets should yield more than liquid ones to compensate for a relative inability to sell. Measuring liquidity is a tricky issue but we use an in-house framework to judge our own assets. This shows industrial assets are more liquid than several other segments over the long term. Attributes include attractive lot sizes, simplicity of tenure, a proven track record in investor flows and a breadth of investor base. In other words, no illiquidity premium should be observed for industrial yields relative to most other segments.
We were provoked into this analysis by several London industrial deals at sub-4 percent yields that challenged assumptions on the sector. Yields have tightened structurally relative to the other traditional sectors in an unprecedented way. Indeed, we confess that we expected the analysis to find an overvalued sector and that we would have to formulate a resultant strategy.
Instead, the evidence supports current valuation yields. On this basis it is not an overvalued sector. It is a fair-valued sector that has been undervalued for several years, in particular over the period following the GFC when income risk differentials narrowed and e-commerce really accelerated. Most of this dynamic is underpinned by structural, not cyclical, factors and is therefore enduring.
There are some risks around this view, as there always are. Should the pace of yield compression continue over 2018 then values will become stretched — but we are not there yet. We are also nervous about the herd. When everyone wants to buy industrial, acquisitions are more challenging and sales become more tempting. Brexit remains an unknown quantity with implications for manufacturers, importers and exporters. A general pricing correction would affect the capital values of lower yielding sectors more than higher yielding ones, all else being equal. However, even with these risks in mind, we believe it is unlikely that industrial yields — in particular those for standard units in southern urban areas — would decompress by more than other sectors.
Within a favored sector, there will still be winners and losers. Older logistics will still have obsolescence risk. Fully occupied estates at market rents look less compelling than those with asset management opportunities and voids on which a new rental tone can be proven. Estates with zombie companies exposed to higher financing costs may well cause trouble for unwary investors. But navigating these risks is possible and there are still intriguing alpha opportunities from urban logistics and intensification of estates.
To return to our Goldilocks analogy, the porridge is “just right”, rather than being “too hot”.
We still see opportunities to take another mouthful before the bears return.
Bill Page is business space research manager at LGIM Real Assets.