Whilst the economic outlook for the UK remains challenging, occupier demand for industrial space* is robust with little current evidence of a slowdown on the horizon. The sector is much more resilient than in previous downturns with the chronic shortage of available space* expected to continue into 2023. Persistent supply chain problems will continue, which may lead to more organisations announcing that they are bringing overseas operations back to the UK to mitigate future disruption.
Demand for space will continue but increasing costs will prove a challenge to the sector
Following 2021’s record level of take-up*, volumes are predicted to subside as we’ve seen already in 2022, but this will have been driven by record-low levels of supply. Availability levels stand at only 4.2%, with a shortage of quality stock coming to the market expected to continue in 2023. The sector will face mounting challenges from rising costs of materials, labour and energy combined with a reduction in demand for goods from consumers as they cut back on retail purchases amidst the cost of living crisis.
In addition, the imminent arrival of rate revaluations will compound further cost pressures to occupiers. This is expected to hit the industrial sector more disproportionately than any other, with values likely to increase by 23.2% across England and possibly higher given inflation’s current trajectory.
UK GRADE A TAKE-UP FOR BIG BOX UNITS (100,000+ SQ FT)
Source: Avison Young
Nearshoring of operations could spur growth
Global supply chains are increasingly coming under review as their frailties have become exposed in the wake of structural changes ranging from geopolitical events to the pandemic. This has highlighted problems with production methods like just-in-time production where the reliance on too few locations has created substantial disruption. To help alleviate this, some companies have announced plans to nearshore operations. A 2022 survey of global supply chain leaders by AI group Interos found that more than half of the respondents were planning to bring suppliers closer to their operations in the coming years. An example of this is British bus maker, Alexander Dennis (ADL), which plans to return its chassis manufacturing to the UK, having produced them previously in Hungary and China. However, nearshoring/reshoring will be a gradual transition due to its complexity as it takes time to find and secure sites as well as the cost implications associated with relocation.
The European Union has activated a €45 billion package encouraging domestic microchip production, a package proposed having seen the drag on domestic production caused by electronic chip shortages from China so we could see UK government support following suit in the coming years. By transforming global supply chains, we believe domestic markets can better position themselves, helped by the inflow of high-skilled technical manufacturing. In turn, this is likely to generate growth opportunities across the UK economy and the industrial sector (via increased space/development requirements) but also benefit consumers due to the produce of higher-quality products by more technical labour.
“Despite the uncertain outlook for the UK economy we expect occupier demand for big-box, grade A space to remain, driven by the continued lack of supply of stock. ESG will remain a high priority for industrial occupiers and investors during 2023.”
Andrew Jackson, Principal & Managing Director, Industrial
ESG to remain a high priority
New build stock will continue to have a heavy focus on ESG credentials, as companies move towards their own net zero carbon targets. We could see an increase in the number of build-to-suit schemes come to the market as organisations look to maximise cost savings, for example, through the creation of renewable energy on site, and then selling this to occupiers at a competitive price which creates a revenue stream. Given their low margins, we have already seen many major third party logistics providers committing long-term to these spaces, a trend which we believe will continue.
Over 90% of existing industrial buildings on the EPC register in England and Wales are compliant with the governments’ minimum energy efficiency standards for commercially leased buildings to be at a minimum EPC E grade by April 2023.
However, moving towards the government’s target of an EPC B grade or higher for 2030 presents a bigger challenge for landlords as only 10% of buildings are currently above this threshold. As a result, throughout 2023 and in future years, we will see landlords upgrade existing stock to be capable of capturing growing occupier demand which is increasingly targeting best-in-class, grade A properties. Upgrading represents an investment opportunity particularly in locations where there is a chronic shortage of quality stock.
Pricing adjustments to continue in 2023
Supply chain problems, high inflation and rising energy costs are likely to continue throughout the year whilst the Bank of England has indicated its intention to continue raising interest rates to reduce inflation levels. This is likely to result in debt finance becoming more expensive, leading to a further softening of yields.
UK DISTRIBUTION EQUIVALENT YIELD
This could result in a reduction in the number of speculative buildings coming to the market as developments without occupier interest may drive lenders to take defensive stances in relation to financing assets under current pricing levels. Pricing adjustments to land values are also expected, but critically needed, to offset the increase in financing to avoid developments becoming unviable - even if build and material costs continue to taper off.
Despite pricing adjustments, there are still opportunities within the investment market. For example, whilst many investment deals were withdrawn in the second half of 2022, the cost of refinancing could see some owners put product to the market to ensure their cash reserves remain in the ‘black’. In addition, we expect to see many institutional funds, particularly closed-end funds, rebalance their portfolios.
The rebalancing will favour the disposal of industrial stock, given its perceived liquidity, and result in offloading stock purchased at yields less favourable than today’s rates but which have seen strong rental growth in the last few years. This presents an opportunity for equity investors who may have felt priced out of the market recently due to the huge levels of overseas investment into UK industrial property, particularly from US capital. So, while there is a lull in activity, with limited buyers circling the marketplace, it provides an (uncharacteristically) less competitive marketplace for opportunistic buyers to benefit from.
*Big Box, Grade A