The retail warehouse investment market is in a state of flux. Prime Open A1 yields started the year at 5.50%. Currently, they sit at 5.75%, having moved out 25 bps in the last month and softened by as much as 50 bps from a low of 5.25% in April/May. Prime restricted yields have behaved no differently, now at 6.25%, 25 bps higher than in January, having dipped as low as 5.75% in the spring.

Meanwhile, UK Bonds have experienced a similar undulation. The ten-year UK gilt yield currently stands at 4.37%, having started 2023 at 3.67%. It briefly reached as low as 3.00% at the beginning of February; however, since then, it has continued to consolidate gains above the long-term average of 4.25%, moving out to this year’s peak of 4.66% in July, as investors prepared for the BoE’s August policy meeting.

The upshot of all this ebb and flow is that overall, retail warehousing, like the rest of UK commercial real estate, has seen a correction in pricing over the last twelve months. The main factor depressing capital values has been the rise in interest rates and the subsequent adverse switch in investor sentiment rather than any fall in occupier demand or negative rental growth.

In June, interest rates reached 5% for the first time since 2008, with the BoE making a 50 bps increase in order to try to curb inflation. As a result, prime yields in the retail warehouse sector moved in step and immediately with the increasing cost of money and subsequent softening of UK Bond yields. Since then, an additional 25 bps increase in interest rates has just been announced for August (now at 5.25%). Time will tell if it will impact pricing further in the retail warehouse investment market.

However, those that take more than a cursory interest in this sector will know, even in the not-too-distant past, when interest rates were below 1%, retail warehouse yields have experienced fluctuation. This begs the question, what else in the market typically influences its pricing?

The answer to this question is undoubtedly the volatility or indeed vitality of the sector occupationally. In 2019 we saw a great deal of investor interest in the retail warehouse sector; pricing looked attractive considering the strength of the occupational market and the potential to add value.

Nevertheless, the pandemic put the brakes on any significant investment activity, as the market paused to see how such a shock event would play out. Since then, we have had a war in Ukraine, which, like Covid, has compounded the current cost of living crisis in the UK. The question is, are the fundamentals that peaked both institutional and overseas investor interest pre-Covid still present in the occupational market?

As discussed in the occupational section of this report, there is plenty of evidence to support the argument for; the good news is the occupational market continues to show its resilience. A strong appetite for expansion remains, which means voids are low and creeping ever lower. Retailer performance has been strong for many key operators, particularly the discounters. Despite the trepidation surrounding the fortunes of the traditional bulky goods ‘big ticket’ retailers (furniture, carpets, kitchens and electricals), grocery, F&B, and value homeware operators have posted impressive revenue results as consumers have swung into belt-tightening mode. As a result, we have seen no significant reduction in the average net effective rents achieved across the sector, which despite the strength of the recent economic headwinds, remain at c.£18 psf, as they have done for the last two to three years.

In fact, it can be argued that average market rents, on prime assets at least, are in some cases artificially lower than they perhaps should be. Fully let schemes seldom present an asset manager with the opportunity to justify an increase in rental value on a new deal. Lengthy WAULTs following the rebasing of rents, strong revenue performance and therefore the majority of retailers choosing to regear rather than vacate, are all contributing factors.

Similarly, the arrival of the never-seen-before insurance lease less than three years ago, and their subsequent swift departure, highlights how much those that understand the market believe in its existing strength. The market is so short of space, retailers have been prepared to put in the time and effort in negotiating a pre-let, despite the likelihood that the opportunity to take that space will ultimately not materialise – just to be at the front of the queue in case it does. However, landlords have all but ended this practice, instead preferring to get any such space back and use it to demonstrate value and improve on rental income.

With competitive tension still noticeably present, why then are retail warehouse yields closely mirroring the rising cost of debt and UK Bond yield movements? It is our view that investors are simply not putting enough weight on the bedrock that underpins the occupational market. We have arguably been at this juncture before, with the relative naivety of some investors in tarring all types of retail with the same brush. However, negative sentiment must catch up with the reality.

Investors have seemingly been left with a choice to make. Do they put their money in lower-risk bond yields, or is there any part of UK commercial property, at its current price, worth the gamble with a potentially stronger return?

Understandably, occupational resilience alone hasn’t been enough to persuade investors to take that gamble in any great numbers in the retail warehouse market. The consumer economic outlook only six months ago was particularly austere, and in reality, many institutional and opportunistic buyers have paused on the predication that assets may indeed get cheaper still; fuelled by the negative impact of 14 consecutive interest rate rises still at the forefront of their minds.

As a result, H1 has seen a total of £1.1bn in retail warehouse transactions, -13.5% down on H2 2022 and -17.9% down on the same period last year. This represents a -14.6% reduction on the H1 average of the last two decades.

Nevertheless, not all investors have been put off by the negative sentiment surrounding the strength of the UK’s recent economic headwinds. 2023 has continued to see activity in the smaller and arguably more liquid lot size arena in particular, as the desire for Prop Cos and high-net-worth private investors to explore opportunities in this sub-sector remains. Particularly with the most recent outward drift in pricing.

There is perhaps cause for even more optimism. As we move into H2, you could argue that some of the negative concerns around the UK economy have significantly dissipated. A UK recession is no longer the consensus view, the winter of 2022/23 was warmer than expected, and wage growth has accelerated. UK Bond yields look to have stabilised for the time being, with 10 Year Bonds currently at 4.3% and 20 Year Bonds currently at 4.5%, following the positive news of a slowdown in inflation on 19 July.

However, this could be tapered by the BoE’s August increase in interest rates. In reality, up to now, the messages around the UK’s economic outlook have been mixed, and the latest news on interest rates may suggest we are not at the nadir in terms of pricing; in the short term, we may see some further rises before we see any falls.

Recent weaker-than-expected economic data has tempered expectations regarding the peak level of BoE interest rates. Currently, financial markets are pricing in interest rates peaking at 5.75% in November.

In the interim, it is our view we will see a pause in yield softening, provided the BoE also pauses for a moment on any further interest hikes, with some clarity needed on whether the changes it started implementing last year are really impacting the wider economy and will bring inflation down further.

On a positive note, with vacancy across the sector so low, and little to no development pipeline in the sector, satisfying retailer demand for acquisitions will only get more difficult, which will continue to inflate the pressure for rental growth. Couple this with clear evidence of sustained interest rate stabilisation in the long term, we expect to see transactional activity in the sector increase over the next twelve months, with a focus on core plus assets for institutional investors and secondary assets for opportunistic buyers, attracted by the softer pricing and opportunity to add value.

Analysts might argue that such a result hinges on two additional key factors. Firstly, the assumption we won’t see a handful of retailer failures in the sector in that time frame. Secondly, how retail warehousing stacks up versus other commercial property asset classes that may have seen pricing move out further and potentially offer a more attractive return.

The counter-argument is again wrapped up in the sector’s strong occupational backdrop. With a finite number of key operators, retail warehousing is indeed exposed to a flurry of potential failures. Current vacancy tells us the market could indeed absorb one or two significant failures that release units back to the market; any more may begin to undermine the sector’s performance.

However, INCANS Tenant Global Score, which is a measure of the financial strength and stability of a retailer based on its public accounts, tells us the financial stability of the sector’s top operators is solid. Of the top 25 larger format operators, in terms of the number of units they have across retail, leisure and shopping parks combined (excluding F&B and gyms), 20 are considered ‘low risk’ or ‘very low risk’ in terms of failure. It is therefore our belief that the risk and return relationship looks much more favourable for retail warehousing than it does other sectors, which don’t have such strong occupational fundamentals.

The fly in the ointment may, of course, be a mismatch between seller-buyer expectations. Vendors will be well aware of the occupational resilience their schemes continue to show, which means fewer could be willing to sell at current pricing levels unless they have to.

_{Read the articles within Spotlight: UK Retail Warehousing below.}