A new chapter awaits
What does the UK Election and the next phase of market growth mean for the industrial and logistics sector?
7 minutes to read
Polling stations and great expectations
With less than a week to go until the nation goes to the polls on 4th July, the industrial and logistics sector is paying close attention to the parties' manifesto promises and potential impacts. While specific details are still emerging, several policy areas could significantly impact the sector, particularly new policies on trade, transportation infrastructure, and environmental regulations.
Over the past five years, the industrial and logistics sector has seen four iterations of an Industrial Strategy, as well as a changing post-Brexit trade environment to adapt to. Both investors and operators within the industrial and logistics sector will be looking for a government and policies that promote growth and stability and support trade.
Business Rates reform?
A potential change in government may bring changes to tax regimes (such as business rates) or regulations around environmental standards, which could pose a risk to the sector. Such changes have the potential to impact business planning and be costly and operationally challenging, especially for small and medium-sized enterprises (SMEs).
All the main parties have looked at the potential for business rates reform. Indeed, the Conservative manifesto pledges to 'continue to ease the burden of business rates for high street, leisure and hospitality businesses by increasing the multiplier on distribution warehouses that support online shopping over time.'
The suggestion is to continue providing business rate relief for the retail sector and to fund it by increasing the cost of business rates for occupiers of distribution warehouses.
But is this needed? The 2023 Ratings Revaluation has already addressed the need for a rebalancing in business rates; the retail sector saw significant declines in Rateable Values, while those for distribution warehouses saw a considerable rise (averaging 32% across the UK).
It's also important to note that not all distribution warehouses are not exclusively used to support online shopping. Retail store networks also require a distribution warehouse, as do suppliers and business-to-business distribution firms. Furthermore, many retail businesses are now omnichannel, selling through brick-and-mortar stores and online. Therefore, it seems misguided to target taxation on a specific type of building to support shopping on the high street.
Getting ahead of the curve
When the Bank of England's Monetary Policy Commission met on the 19th June, they voted to keep the Bank Rate at 5.25%. The decision was reached with a 7-2 majority, with two members voting for a 25bps cut.
Oxford Economics has revised its expectations around the timing of the first cut, which is now expected to come in August, with a total of 50bps cuts anticipated by year-end. However, as of Thursday, 27th June, Overnight Index Swaps suggest September may be the most likely date of the first rate cut, with an interest rate of 4.79% priced in for year-end.
Oxford Economics forecasts a further 100bps cuts in 2025, taking the policy rate to 3.75%. However, markets are pricing in fewer cuts for 2025, with 4.14% priced in for the end of 2025. While the forward curve should not be mistaken for a forecast, markets clearly expect interest rates to remain high for longer.
As interest rates fall, gilt yields are expected to sharpen, making current industrial and logistics real estate yields more attractive (relative to fixed-income investments) for investors. Ten-year government bonds are expected to be 4.03% in Q4 2024, reducing further throughout 2025, to reach 3.71% by Q4 2025 (Oxford Economics). This should boost investment market activity through the second half of 2024 and into 2025.
Higher for longer
The rise in interest rates has reduced the predictability of yields and real estate cash flows. This has upended investor strategies, resulting in a significant slowdown in development and investment transactions.
More active management will be needed to drive returns over the next 5-10 years. The burden of higher interest rates and cost of capital will mean that opportunities for generating growth will be led by asset specific or local market level factors. Industrial and logistics assets that offer an opportunity for value-add returns will therefore, prove favourable.
Higher interest rates and inflation will mean that some industrial and logistics investors/landlords may reexamine their preference for open-market rent reviews, with leases linked to inflation offering greater income certainty.
An extended high interest rate environment and ongoing inflationary pressures will continue to dampen construction activity into 2025, meaning good quality, new build stock will remain in short supply. Preliminary figures for Q2 indicate that vacancy is still rising, but at a slower pace than in previous quarters. Despite the uptick in vacancy rates in recent quarters, operators face limited options in many locations and across certain, particularly larger size bands.
The higher cost of capital may limit the growth opportunities for less-established companies or nascent sectors, which tend to rely on debt to finance expansion. Higher inflation and financing costs will drive many occupiers to focus on profit growth and managing their cost base rather than expansion. While this likely means that take up volumes will not return to the levels recorded in 2020/2021, it will also mean that companies exercising expansion plans tend to be well-capitalised, meaning greater income security for landlords.
History doesn't repeat itself, but it often rhymes
This market cycle is proving different from previous cycles, and thus challenging to draw parallels. While no two economic cycles are the same, as the American writer Mark Twain said, "history doesn't repeat itself, but it often rhymes".
Returns across all asset classes are unlikely to achieve those of previous cycles, and a smaller performance advantage for real estate over fixed-income gilts is expected.
Annual total returns of over 40% were recorded for UK industrial property in early 2022, far in excess of returns for other property sectors. Though forecast returns are lower than those reached during the previous cycle, they are still significantly higher than other asset classes and other property sectors, with 8.1% CAGR forecast 2024-2028 (RealFor).
Given this positive outlook for returns and the material repricing of logistics assets over the past couple of years, now presents an attractive opportunity to enter the market. Industrial and logistics assets have repriced faster than other sectors and faster than in previous market cycles. Valuations now appear to be stabilised, with the MSCI monthly index recording positive capital growth for the past two months (to May), and the equivalent yield softened by just 2bps in May (the same yield shift in April).
The industrial market has greater resilience than in previous cycles
In previous economic downturns, the fortunes of the industrial and logistics sector were tied more closely to the manufacturing sector. While manufacturing remains an important driver of demand, the occupier base has broadened significantly over the past decade due to several factors, including the growth of e-commerce and the associated rise in demand for logistics and home delivery services.
In urban locations, the combined impact of rising urban populations, economic expansion, and increased demand for online retail and home deliveries have had a dual effect: constraining supply whilst increasing demand for industrial and logistics facilities. Much urban industrial land has been lost to housing over the past twenty years. The removal of large swathes of industrial land will mean that vacancy rates; particularly in urban areas; will not rise significantly or to the same levels seen during the previous market cycle.
Urban locations also have a far cleaner and more diverse occupier mix than they used to. Industrial and logistics facilities are increasingly used for courier services as well as offsite service-based activities such as laundry services, catering, coffee bean roasting etc. Alternative uses such as leisure have also sprung up, with climbing centres and trampoline parks occupying warehouse facilities.
Another source of demand stems from the rise in digitalisation. Rising data consumption and increased demand for content streaming platforms have driven demand for data centres and for film studios, which often locate on industrial land or adapt industrial facilities. These additional demand pressures will continue to fuel a demand-supply imbalance for the sector.