Rising interest rates and debt costs drive repricing in prime logistics markets
All-in cost of debt rises but asset quality will prove important for investors.
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Industrial yields have been at historically low levels and rising interest rates have driven the all-in cost of debt above prime logistics yields in some markets and yields have softened as a result.
The Bank of England’s Monetary Policy Committee (MPC) raised interest rates by +50bps on 4 August. With all-in debt costs at or above prime yields, there is little or no income coverage and leveraged investors will find it difficult to make purchases stack up with current pricing.
All-in cost of debt
Senior lending margins for prime logistics assets (1.65%) plus the 5-year SWAP (2.28%, as of 4 August) brings the all-in cost of debt for prime assets to 3.93%. At the end of June, prime distribution units offering 15-year income (open market rent reviews) were at 3.50%. However, prime yields have come under pressure and moved out +25 basis points (bps) in July and are now at 3.75% (Knight Frank Yield Guide).
While rising financing costs, along with heightened levels of risk are likely to put pressure on loan-to-value ratios, the availability of debt remains. There are a large number of lenders in the market, with debt strategies targeting the logistics sector. Cash flow or rental income (and rental growth prospects) will be increasingly important for both investment and lending decisions.
Investors are hedging against interest rate volatility and updating their debt facilities with interest rate caps. At this point in the cycle, accessing the right financing at competitive terms will be of heightened importance.
Rental growth prospects
Despite higher financing costs, many buyers in the market are well-capitalised and not reliant on debt. Cash flow or rental income (and rental growth prospects) remains key to their purchasing decisions. The logistics occupier market remains strong and the undersupply of stock is continuing to fuel rental growth. Despite the backdrop of a weakening economy, industrial rental growth remains firmly in positive territory and is expected to remain strong, and outpace that of other sectors.
The monthly MSCI rental growth index showed a slight acceleration in June, though the broader trend over the few months has been one of slowing growth. Expectations for further rental growth across the UK market this year have been revised down, though the shift in outlook has not been uniform across the UK, with improving growth prospects in some regions and markets.
Occupier market pressures
There are headwinds for the occupier market however. Logistics operators and manufactures now face a perfect storm of rising cost pressures; from fuel and energy costs, to raw materials and labour. This has been further compounded by supply chain issues stemming from the war in Ukraine and ongoing lockdowns in China. At the same time, consumer and business confidence, along with order book volumes are waning. A recession is likely to mean some business fall-out which could drive up vacancy rates in some markets.
Development activity is also rising, and higher levels of availability could also push up voids and dampen expectations for rental growth in markets with large amounts of speculative construction. However, we don’t expect to see an oversupply.
Higher financing and build costs are curtailing developers’ appetite for risk and much of the increase in construction has been driven by built-to-suit facilities rather than speculative development activity. New, well-located facilities that can offer improved operational efficiencies, and help occupiers lower fuel and energy costs will remain desirable.
While interest rate pressures are impacting prime assets/markets with the lowest yields most, a weakening in the occupier market would hit income-driven markets, secondary distribution units and poorly located multi-let estates hardest. Comprised of a higher proportion of SME businesses, with weaker covenants, the tenant base in these markets will be more exposed to an economic downturn.
Asset quality
The occupier market remains on firm footing. The structural drivers that underpin demand for the sector centre around population growth, urbanisation, higher levels of online spend, and consumers’ demand for convenience. Despite inflationary pressures, well-located, high quality facilities will continue to appeal to both investors and occupiers. As the economic cycle progresses, and as sustainability becomes vital for future proofing returns; the importance of asset quality and covenant strength will be magnified for investors.