Why invest in manufacturing real estate?
The future prospects for the UK manufacturing sector appear bright. Expansion of the sector is anticipated to accelerate over the next ten years…
10 minutes to read
The future prospects for the UK manufacturing sector appear bright. Expansion of the sector is anticipated to accelerate over the next ten years (with 12% output growth by 2033, compared with 8.6% in the past ten years, according to Oxford Economics).
Manufacturing and production assets can also offer diversification benefits for real estate investors as a distinct asset class from logistics (B8) or other CRE sectors. Average rental growth for manufacturing and production assets has outpaced that of most other sectors.
Strong levels of business investment in manufacturing, supportive government policies (around taxation), and targeted government investment can work to promote stability in the occupier base, thus offering landlords means navigating the nuances of different segments of the market, with differing growth prospects improved covenants and strong growth prospects.
However, prospects are not equal for all subdivisions, and therefore, risks vary according to sector. Covenant strength can differ greatly from business to business, even within high-growth subdivisions, resulting in a need to understand the composition and drivers of the manufacturing sector in more detail.
There are also specific nuances attached to the sector’s underlying real estate, and this can pose both risks and opportunities for investors. Robust levels of investment in their businesses, technology, and facilities mean that manufacturing tenants tend to seek longer leases. These longer leases can provide investors with a stable and predictable rental income.
However, manufacturing firms tend to have more bespoke building requirements with features specifically targeting their operational requirements; these may relate to building dimensions, fit-out or energy provision requirements, or other features relating directly to their operations. Some operations may co-locate manufacturing functions with office-based operations, research and development, or distribution functions. This can mean a highly bespoke facility that would not be easily re-lettable should the tenant default/vacate.
RENTAL GROWTH
As well as lower vacancy and longer lease terms compared with other property sectors, rental growth has also compared favourably. Rental growth for manufacturing and production assets correlates strongly with that of warehousing and distribution, with strong rental growth exhibited over the past ten years and particularly over the past five. Rental growth for manufacturing and production has slightly lagged that for warehousing and distribution but outpaced that of all other sectors.
In the last five years, landlords have held a strong negotiating position, due to low vacancies and robust tenant demand. With strong rental growth, landlords have sought open market rent reviews. This, along with shorter lease terms, has enabled stronger rental growth for warehousing and distribution assets.
As facilities tend to be more bespoke, manufacturing and production assets have longer leases and a stronger tendency towards index-linked rent reviews. These typically have a cap and collar mechanism, which sets the minimum and maximum rise (typically set at 2% and 5%). This has capped some of the rental growth experience in this segment of the market.
However, with vacancy rates having risen significantly in recent years and rental growth for industrial and logistics assets expected to slow over the next five years, index-linked rent reviews may become more prevalent for warehouse and distribution assets.
'STICKY' TENANTS
Manufacturing firms invest heavily in their businesses. They often install expensive equipment in their facilities and invest in training and development for their employees, who need specialist skills and training to operate this equipment. Businesses investing heavily in their facilities and the local labour pool are less inclined to relocate. For landlords, this can mean ‘sticky’ tenants who are less likely to exercise break options and more likely to renew at the end of a contract term.
Manufacturing tenants tend to opt for longer leases on industrial and logistics assets compared with distribution or retail firms. Over the past five years, new leases for manufacturing firms have averaged 12.1 years, compared with 10.7 years for distribution firms and 11.5 years for retail firms.
With many manufacturing operations highly automated or mechanised, firms invest heavily in their plant and machinery. According to the Make UK/RSM UK Investment Monitor Survey 2024, almost two thirds of manufacturers (64%) invest up to 10% of their turnover in plant and machinery, with a further 26% investing 10-50% of turnover.
Manufacturing equipment is typically very costly to install and may be difficult – and expensive – to remove. It is also usually highly specialised in terms of its functionality. A vacant building, therefore, has a lower prospect of being relet with the equipment in situ and a higher cost associated with refurbishing the building and removing equipment.
However, firms planning this form of investment will weigh up their future demand projections alongside risks associated with levels of future demand, the tax implications or potential changes, and the costs associated with financing this investment. Firms typically amortise their investment into machinery over the length of their lease. With the installation of costly equipment that is often bespoke or customised, long leases are often favourable.
BUSINESS INVESTMENT AND SUPPORTIVE GOVERNMENT POLICY
Across manufacturing, business investment has more than doubled over the past ten years. Substantial increases have been recorded in the past three years, with government policies introduced to help boost investment (and soften the impact of rising corporation tax).
In March 2021, then-Chancellor Rishi Sunak announced the introduction of the ‘super deduction’ and the ‘Special Rate (SR) allowance’. Originally announced as a temporary measure (to expire in 2023), the UK Government subsequently announced that the relief will remain permanently in place. Effectively, the (now-permanent) full expensing allowance means companies should receive a 100% first-year tax deduction for expenditure on qualifying plant or machinery - essentially reducing the in-year cost of plant or machinery by 25%.
These tax breaks have acted to incentivise business investment, and their continuation will provide firms with certainty around expenses associated with capital investment and enable them to better plan for business expansion and investment in the coming years.
For institutional investors seeking a long-dated secure income with minimal active management requirements, industrial facilities focused on production (typically B2) or B8 facilities that manufacturing firms occupy, could offer an attractive risk/return profile with tenants’ growth and investment plans supported through government policy and where investment is focused on their facilities, incentivising them to remain in-situ.
BUILT ASSETS AS AN ALTERNATIVE TO DIRECT INVESTMENT
There is, of course, more than one way to invest in the growth of a sector. For alpha-driven investors, equities will offer the most significant potential, but for institutional investors concerned more with wealth protection and inflation hedging, fixed-income options such as corporate bonds and real estate may offer greater security of income. Real estate has the added advantage of being a tangible asset, which can provide additional security and stability and help limit downside risk, with underlying value in the land and built assets.
HOW DO YIELDS FOR MANUFACTURING PROPERTY COMPARE WITH CORPORATE BONDS?
Yields for manufacturing assets tend to compare favourably with corporate bond yields for manufacturing firms.
Similar to real estate (or gilts), corporate bond yields typically offer fixed cash flows. These tend to be at a higher yield than gilt yields due to the additional risks attached to corporate covenants. Individual corporate bond yields reflect the risk perceptions associated with the manufacturing sector as a whole, the specific subsectors in which the company is active, and – most importantly – the strength of the company's corporate covenant. These factors (along with real estate-specific ones) can also influence yields for these companies’ real estate assets.
Quantifying the difference between corporate bond yields and real estate yields is difficult due to a lack of comparable data. We can, however, consider individual examples of corporate bond yields and how these compare with the real estate benchmark yields. Our Knight Frank Prime Yield Guide indicates c.5- 5.25% NIY for prime distribution and warehousing assets with 15-20 years income (December, 2024). While yields for manufacturing assets tend to be higher than distribution assets (as evidenced by the MSCI index and individual transaction examples), we can compare this benchmark with ‘prime’ or investment-grade corporate bond yields. Manufacturing companies, Honeywell International, Airbus, BAE Systems and Unilever, together, have corporate bonds (maturity dates 10-20 years), averaging a yield of 4.1%. Of course, within this sample, there are variations in terms of corporate credit ratings and manufacturing subdivisions that will influence these yields.
TENANT COVENANT
Of course, tenant covenant strength can’t be assessed at a sector or subsector level. However, we can take the pulse of the market in a broad sense by considering business survival rates.
There is great variety in the success rates according to different manufacturing sub-sectors. Across all businesses established in 2018, 39% were still in operation five years later. Manufacturers of textiles and wearing apparel tended to fare worse, with lower success rates of 30% and 37%, respectively.
"Manufacturing tenants tend to opt for longer leases on industrial and logistics assets compared with distribution or retail firms."
However, many manufacturing sub-sectors fared better than average, with a success rate of 56% for beverage manufacturers, 53% for manufacturers of rubber and rubber products, 47% for manufacturers of food products.
Interestingly, the two sectors with the poorest survival rates were warehousing and support activities for transportation and postal and courier activities. Operating on thin margins, companies in this segment of the market have been hit hard by rising inflation and spikes in shipping costs. Furthermore, the rapid expansion of the online retail market has been a key driver of growth in this segment of the market in recent years. However, some online retail operations overexpanded, particularly during the pandemic and there were cases of third-party logistics firms (3PLs) having contracts terminated. These factors are likely to have weighed on the survival rates of firms in these sectors.
The manufacturing sector encompasses many different subdivisions, with products going to various different applications and markets. The markets and drivers influencing demand are numerous and varied, and this is reflected in the variation in survival rates across sub-sectors.
Covenant risk is perceived as a more significant factor for an asset that is designed and built with high levels of customisation for the tenant or in a market with a shallow occupier base or high vacancy rates; it is also given heightened consideration in an economic downturn. In the down cycle, lease length normally becomes more relevant due to a lower probability of reletting, weaker prospects of rental growth, and increased risk of default.
Covenant strength risk is factored into and included within the risk premium over conventional gilts. The average equivalent yield for manufacturing/production property is currently 6.3%, according to the MSCI Quarterly Index, compared with 6.1% for warehouse and distribution assets (September 2024). Manufacturing and production assets, therefore, have a greater spread over gilt yields. At the end of September, the spread was 234 basis points (bps), compared with 206bps for warehousing and distribution assets. This higher yield premium may reflect a higher risk associated with more customised facilities and a shallower occupier base. It may also reflect a higher perceived risk associated with the occupier base.
"The markets and drivers influencing demand are numerous and varied, and this is reflected in the variation in survival rates across sub-sectors."
For almost ten years, from Q3 015 to now, yields for warehousing and distribution assets have been lower than those for manufacturing assets. However, yields for manufacturing and production assets have not always been above those for warehousing and distribution. During the previous five years (Q3 2010 – Q2 2015), yields for manufacturing and production facilities were generally lower. This was also the case between Q1 2001 and Q4 2005.
