Have logistics and industrial assets been oversold?
The strong occupier fundamentals in the industrial and logistics sectors together with relatively strong balance sheets lead us to believe that the sector has been oversold.
As global market jitters heighten, the sell-off of real estate investment trusts (Reits) has been dramatic and especially painful for industrial and logistics-focused funds.
Reits are concerned that inflation has triggered high interest rates resulting in asset value declines.
In the UK, where political instability has been thrust into a skittish economic environment, the average discount among the eight London Stock Exchange-listed, industrial and logistics-focused companies has widened to 37.5%.
New York Stock Exchange-listed and the largest global Reit, Prologis saw its shares tumble 40% from their peak earlier this year.
Six months ago, most industrial and logistics Reits were trading at hefty premiums. In spite of these sudden discount ratings, demand for industrial and logistics space is growing.
Industrial vacancy rates (a key real estate metric) are very low at around 3% in the UK and Europe. This suggests that substantial rental growth will continue.
This seems to be a global trend, and Prologis hasn't experienced any slowdown despite its share price taking a beating. In its financial results for the third quarter, rental income surged 12.6%, while asset management income grew over 65%. If they are the bellwether of logistics real estate, their record 97.8% occupancy is indeed a positive sign.
Valuations under pressure from rising rates
A higher interest rate environment has brought into sharp focus the valuation of commercial real estate as rising rates put pressure on investment yields. The UK swap rate (the rate at which banks add their margin for lending to real estate) has quadrupled since October 2021. The five-year Euribor swap rate (the European equivalent) increased from -0.099% to 2.985% during the same period.
Lack of low-cost finance has resulted in many leveraged investors exiting the market, and the pressures that underpin pricing have been removed.
As values fall, loan-to-value (LTV) covenants could come under pressure. Refinancing loans at the end of their term could also become impossible for highly leveraged real estate companies, forcing a fire sale of assets and driving a further decline in values.
This is likely to be the case in certain retail and most office real estate sectors, where values have fallen over the past few years. However, the industrial and logistic sectors have seen sharp rise in values during the same period.
By how much values would fall in the industrial and logistics sector (which has seen values rise furthest over the past decade)? It is too early to say, and this depends on several factors, including how long it would take to bring inflation under control.
Leading global investment banking and asset management firm, Goldman Sachs predicts that commercial property values in the UK will fall by between 15%-20%. Oxford Economics and Bayes Business School forecast values to fall by up to 35% – mainly in the retail sector.
Tenant demand for logistics and industrial remains high
The importance of rental growth is critical. On the demand side, logistics and industrial property remain resilient with global take up of space including South Africa reaching new highs.
The effects of e-commerce are still playing out, along with a resurgence in demand from the manufacturing sectors. Concerns over supply chain dependence, onshoring, and the need to hold more inventory lead to more demand for space.
As industrial and logistics yields move out, rental growth in the sector will play an important role in curtailing the impact on values.
Many industrial and logistics property companies have focused on innovative asset management initiatives to capture rental increases borne out by the supply and demand dynamics in the sector.
A great example is UK-based Industrials Reit, a specialist multi-let industrial property company. Industrials Reit has a dual listing on the London Stock Exchange and the Johannesburg Stock Exchange.
Similar to Inospace in South Africa, the fund has developed a technology-enabled operating and leasing platform that has improved its performance and reduced costs across the business. Industrials Reit hopes the platform will transform how its multi-let industrial units are managed in the future, in line with other customer-focused property sectors such as self-storage, student accommodation and hotels.
So is this the time to buy?
In last month's Industrial Club article, I asked the same question. Predicting where interest rates and real estate prices will go from here is still murky. But if one looks through the current interest rate cycle, and trusts that inflation will be brought under control at some point, then real estate values will rise again as the cost of capital reduces.
Coupled with the strong occupier market fundamentals and the relatively strong balance sheets (conservative LTVs, a high percentage of fixed/hedged debt and long maturities) should lead us to believe that logistics has been oversold. This could be a perfect time to enter the market.
(This article can be be read in November issue of Asset Magazine)