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With a bleak economic picture, consumers and companies are feeling the strain that things could get worse before they get better – what impact could continued economic volatility have on the market?
The macro picture
Are we in for a hard landing?
The impact of higher interest rates has become increasingly apparent across a plethora of economic indicators and real estate data. Tighter credit conditions and rising finance costs inevitably have slowed business activity. Higher interest rates are typically understood to affect the economy on a lag and can take up to 18 months for their full impact to be felt. In the logistics real estate market, leasing activity and investment volumes have dropped sharply. While yields have responded, rising over the last year, the increase was substantially less than the 10-year government bond yields. Conventional wisdom dictates that yields must adjust further to compensate investors for taking on risk.
While market expectations of rate cuts have shifted from early H2 2024 to April, we caution that this does not necessarily bode well for the economy. The European economy shows clear signs of slowing, with core consumer prices now well below the 2% target rate. Job vacancies are falling, and wage data, which is released on a significant lag, shows signs of softening. While the US looks like it may achieve a soft landing, the EU looks set for further economic stagnation in 2024. As the UK’s largest trade partner in the aggregate, weakness in Europe will inevitably create a drag on the UK’s growth.
Short-term indicators of business activity show significant weakness
Alongside contractions in the services and construction purchasing manager indices, the S&P UK Manufacturing PMI recorded an eight consecutive month of decline in October – the longest continued decline since the GFC. While take-up from manufacturing occupiers has held up remarkably well this year, there are clear signs of strain in the sector, with business optimism dropping to a ten-month low. The decline in business optimism has been driven by concerns about consumer uncertainty and the cost of living crisis. Weaker manufacturing output will weigh on demand from both manufacturers and 3PLs.
Mortgage rates are putting pressure on households
High interest and inflation rates are now clearly impacting consumers, feeding through into higher mortgage repayments for mortgage holders, which inevitably puts further pressure on households’ finances. Indeed, The value of outstanding balances with arrears increased by 13% over the quarter and 28.8% over the year, to £16.9bn in 2023 Q2, and now accounts for 1.02% of outstanding mortgage balances. The pressure on mortgage holders and rising prices have inevitably cut into real consumers' disposable incomes, which have fallen by 0.5% between Q1 2021 and Q3 2023 and will inevitably lead to declines in spending on consumer goods. Indeed, while the value of retail sales (ex. auto fuel) has grown by 4.7% year on year in September, the actual volume of goods bought has declined by -1.0%. Ultimately, this means a decline in the volume of goods moving through the economy which, in turn, would suggest less product will need to be stored in warehousing in the short term.
The market picture
Buildings are starting to remain vacant for longer
Whilst the void period for units that have leased remains broadly positive this only really gives us half of the picture. If we examine our supply data and analyse how long units have been vacant for at the end of any given quarter, we can see that a trend is emerging, showing that units are sitting in our supply database for longer.
Indeed, at the end of 2022, there were 26 units vacant that had been on the market for between six and twelve months – that figure is now 78. A similar pattern emerges if we look at units that have been vacant for 18-24 months, having risen to 36 units at the end of 2023 from just seven at the start of 2022. Conventional wisdom would suggest that the longer a unit has been vacant, the more likely favourable terms are offered to any occupier to secure a deal.
It should, however, be noted that pre-Covid, around 30% of all supply had been on the market for more than two years, and at the moment, just 10% of the total supply has been on the market for this amount of time.
Are occupiers under more financial strain?
With economic data being increasingly volatile, many occupiers are adopting a wait-and-see approach, and as a result, take-up, particularly from retailers, is at suppressed levels. Indeed, since 2007, retailers have accounted for 60% of total take-up. However, a lack of new leasing activity isn’t the only cause of concern: the financial credibility of many large occupiers needs a careful eye.
If we look at retailers with a poor INCANS™ Tenant Global Score, which predicts the likelihood that a company will seek credit relief or worse, go out of business within the next twelve months, we can see that the ‘at-risk’ retailers would return 12.2m sq ft of warehouse space to the market if they were to cease trading.
Feeding this into our vacancy projecting model, which also analyses the level of lease events at risk of being exercised, we find that the vacancy rate would rise as high as 8.58% if this scenario were to play out.
Build to Suit Stagnation?
Over the last decade, BTS deals have accounted for 44% of the total market, and in the last year, the level of BTS transactions has dropped by close to 80%. Whilst overall deal counts remain robust, if the market is to return to take-up levels in excess of 40m sq ft, the BTS market needs to rebound. Given that the market is not expecting base rates to fall until the second half of 2024, the outlook for yield compression remains uncertain, suggesting forward funding for complex BTS transactions will remain a challenge.
What will happen to these requirements if they can’t be satisfied via BTS? The optimistic view would be occupiers will take stock of their options and finally decide to proceed with an existing building. The pessimistic view, however, would be that occupiers decide to either push their requirement further into the decade in the hope that capital markets return to a level that allows a BTS deal to take place, or even worse, the requirement is shelved altogether as the operation is too bespoke to fit into an existing building.
If the latter option prevails in the minds of most occupiers, then it is unlikely that we will see take-up rebound to the levels the market has become accustomed to.
Wider issues
Changes to business rates could threaten development viability
Whilst much fanfare was given to the recent business rates revaluation and the potential for occupiers to alter their occupation strategies, there has been negligible impact on occupier demand, at least that can be traced back to a higher business rates bill in isolation.
The Non-Domestic Rating Act 2023 recently became law, which has introduced wider powers for local authorities to issue completion notices on not only new space, but also refurbished existing space. A new ‘duty to notify’ has also been introduced which will require occupiers or owners to notify the VOA of any changes to property within 60 days of completion, whether they are already assessed for business rates or are yet to be assessed. The combination of these changes will inevitably increase the potential for Completion Notices to be more widely used in the future.
The UK Government also recently finished its Business Rates Avoidance and Evasion consultation, and whilst the results of that are yet to be published, there is an expectation that this could have far-reaching impacts, particularly for developers of speculative schemes. Until details are confirmed, these could include increasing the minimum period a property has to be occupied before being able to qualify for empty rates relief from six weeks to six months or restricting the number of times this can be done in quick succession.
For developers, this will be another escalating cost to contend with and could impact the viability of future speculative development.
Don’t expect too much from the planning system in 2024
On one hand, it could be argued that the government is taking a proactive approach to the planning system, with recent publication of the Levelling Up and Regeneration Act (LURA)and the recent Department for Transport call for evidence covering freight and logistics and the planning system.
However, 2024 is all but certain to be an election year, so the political will to deliver real change to the planning system in 2024 is likely to be limited and we are unlikely to see significant investment in resourcing to mitigate the current delays in the system.
More to contend with for the builders?
As 2023 progressed, we started to see increased pressure on contractors, and in September, it was announced that Buckingham Group, a major contractor in the industrial and logistics sector, was appointing administrators, with over 500 jobs lost. As we head into 2024, developers and investors will need to be increasingly vigilant when appointing contractors to deliver new schemes.
Related to this is the price and availability of steel, a key component in any new logistics build. Whilst the price of steel has fallen from the peaks seen during the Covid-19 pandemic, it remains volatile, currently sitting at circa £1,900 per tonne.
Perhaps more concerning, however, are the recent announcements by British Steel that they intend to close several UK blast furnaces and replace them with electric arc furnaces. Whilst this will help the UK steel industry go some way to mitigating its carbon impact there will be knock-on implications. The steel produced by the new types of furnaces is not classified as ‘virgin steel’ and is therefore not suitable for a number of uses. The knock-on impact of this may be that developers have to source the steel they need from overseas suppliers and therefore incur more cost and not gain any ESG benefit as the carbon impact is simply moved from one location to another.
The emergence of stranded assets?
Logistics as an investment asset class is still relatively young when compared with other sectors, with the first generation of logistics buildings delivered in the late 1980s as the grocers looked to modernise their supply chains for the supermarket era.
These first generation of buildings are, in some cases, approaching the end of their initial leases and discussions are now starting to emerge if they are at the end of their useful lives as logistics assets.
Whilst the location of many of these buildings is unparalleled, consideration will have to be given not only to the physical characteristics of the height, doors, and yard but also to the environmental performance of the building. With the rental spread between prime and secondary buildings now at its highest level, there is a clear case for the owners of buildings to make the required improvements when presented with a void. But with costs increasing, will it be viable to improve the existing stock, in its entirety, when it becomes vacant? Indeed, Savills estimates that it will cost in the order of £9.5bn to increase the EPC levels of all UK warehouse stock to a B level.