Is it too late to join Aim’s warehouse party?

Logistics Reits have had a good pandemic, but can their growth continue as the world normalises?

Even in a rather sedate sector, the Aim 100’s handful of property companies largely live up to the junior market’s billing as the place to find growth, and there’s a simple reason why: e-commerce.

Two of its three property companies, Warehouse Reit and Urban Logistics Reit – the latter of which has announced plans to move to the main market – are involved in the supply of ‘last mile’ urban warehouse space to the online retail industry, which is in short supply at the moment thanks to changing shopping habits and the Covid/Brexit induced supply chain crunch.

Source: SharePad

Since flotation, both have delivered very strong, accounting returns – the movement in net tangible assets plus dividends paid in the period- and unlike the Aim 100’s other property constituent, Secure Income Reit, their shares have shot past their pre-pandemic highs leaving both trading at notable premiums to the value of their assets, indicating the strength of sentiment towards the asset class.  Warehouse Reit and Urban Logistics currently stand at premiums of 6 and 7 per cent, respectively.

Price versus NAV

Source: SharePad

That leaves investors with the obvious question of whether the subsector is too expensive. Strong results from the two companies last week clearly demonstrate why there’s such confidence in the outlook for logistics property. But the premium valuations are demanding a lot of future growth from both companies – and even more at main market peer Tritax Big Box Reit which stands at a near 25% premium – and don’t account for the possibility that the ‘easy’ money in logistics warehousing has already been made.

Source: company accounts

There has been a softening of premia after recent figures from both companies, but still suggest logistics property remains undervalued and will be revalued higher, or that the companies will be able to develop more space to expand their portfolios. Neither is a given; accounting returns are slowing, and the strength of demand for assets means the companies are having to work their existing portfolios harder to keep them going – what’s known in the industry as asset management, an approach which drove nearly three quarters of Urban Logistics’ upwards revaluation in its latest figures.

Running with the bull case

Nevertheless, the bull case is still very easy to make. E-commerce was booming before the pandemic, got even stronger during lockdown, and is proving a sticky trend even as some life returns to the high streets. That means online shopping fulfilment is going to need more and more space – another 60m square feet according to Forrester Research, which is approaching double the combined amount of vacant warehousing (20m square ft) and space under construction (16.4m square ft).

Meanwhile, the supply chain disruption witnessed this year has also prompted all kinds of industries to take more warehouse space to build stocks of parts and finished goods to avoid shortages – as it is often described, a shift from “just in time to just in case.” Both Reits point to a market with record levels of take-up, falling vacancy rates – down from 20% across the market in 2010 to less than 4% in 2021 – and rising rents, driven upwards by the strength of demand and constraints on new construction including rising build costs.

That last factor is especially important in understanding why the sector has traded at a consistent premium to NAV – if building new space becomes more difficult or expensive, the cost of renting it will rise and push valuations upward, simple supply and demand at work. That’s exacerbated by the fact that although there is 20m square feet of available warehouse space on the market, most of this is lower quality second-hand stock which isn’t always suitable for use in modern logistics. 

That imbalance is one reason for the regular upward revaluation of both companies’ portfolios – in Warehouse Reit’s case a 9.3% increase in the 6 months to September 2021, and an 11.5% increase at Urban Logistics. New tenants are being signed on long-leases, and in both cases the average length to lease expiry continues to expand, which also means vacancy rates are very low. Unlike some areas of the commercial property market, rent collections have been largely unaffected by the pandemic, remaining in the high 90th percentile, and by having lots of smaller tenants rather than a few large ones, the risk of rent arears is lessened.

Source: company accounts

Where are the bears?

The current strength of the logistics market has been a powerful tailwind for the two companies, and a trend that seems hard to bet against – the handful of brokers covering the shares are universally positive, with consensus buy ratings and target prices 10% ahead of current levels. Urban Logistics boss Richard Moffitt has spoken of a “permanent paradigm shift” in urban distribution markets.

But investors should be mindful that the market tightness may turn out to be a double-edged sword, and that the idea of a paradigm shift might be overegging the pudding.

In particular, competition for new assets is intensifying, which means tightening yields across the subsector – put simply, property values are rising faster than rents, meaning the returns to their owners are getting lower. Yields in premium ‘big box’ facilities have fallen to around 3% and analysts suggest they have further to fall, with the obvious implication that either buyers pay up and accept lower returns, or compromise asset quality.   

Source: company accounts

That’s a worry, because acquiring new properties is key to further growth. Both companies have strong balance sheets and plenty of headroom to fund further expansion – in both cases the loan to value (LTV) ratios are well below the levels of around 35-40% at which both companies say they are comfortable. But higher purchase prices could lower future returns, albeit from currently high levels, especially if interest rates rise as expected and the cost of financing those acquisitions increases. And investors should be wary that both companies have regularly raised money via large placings, with potentially dilutive implications for existing shareholders – in other words, expansion comes at a price.

Source: company accounts

Developing new assets rather than acquiring them is another route to expansion. But the same constraints on new build that are driving values higher also mean that the returns on development assets are also likely to be lower. These constraints include the rising cost of materials including steel, higher labour costs, and planning issues; getting approval for new sites can take years.

And while both companies have been able to squeeze higher rent out of new tenants, frequently above the markets estimated rental value (ERV), the shortage of quality space and the desire to avoid supply chain disruption mean many tenants are currently opting to stay put. That creates a more stable rental base, and longer lease lengths, but also means fewer opportunities to re-let properties at higher rents, and a widening gap between the rent roll and estimated rental values over time. That shouldn’t dampen the potential valuation uplifts of existing properties, but it could impact the trading performance and limit the profits from which dividends are distributed.

Looking at the longer-term outlook for the market, while e-commerce is likely to remain on an upward trajectory – a structural rather than cyclical shift – it’s difficult to say if the same will be true of the near-shoring trend. It’s almost certainly true that at some point in the not-too-distant future many of the supply chain pressures we’re currently experiencing will dissipate, and a possibility that companies may once again shift to leaner, more capital-efficient models.

Interest rate increases are also likely to see a dampening effect on property values across all sub-sectors of the property market, but it will be those that have seen yields compress the most where returns are most likely to be affected as the premium over the risk-free gilt rate narrows. And in combating inflation with rate hikes, the risk of a broader economic slowdown also rises, which raises the risks of rental arrears and vacancies.   

Keeping their noses in front

None of this is to say that the subsector won’t continue to prosper. Both companies are, as you’d expect, working hard to overcome these challenges, successfully so far.

In its latest figures, Urban Logistics argued that it wasn’t seeing the same kind of yield compression in the area of the market it’s focusing on – small urban boxes rather than big out-of-town ones – and that it had been able to deploy £134m on new assets at initial yields as high as 8.2%. It also pointed to a pipeline of over £400m potential new properties, albeit at lower initial yields, with recent fundraisings and low LTV giving it plenty of financial ammunition to deploy. It raised £108m earlier this year and has announced another £200m placing today at a 4.2% discount to the share price ahead of a planned move to the main market, scheduled for 7th December. That move will improve liquidity and could attract new investors, especially those looking across at pricier peer Tritax.

Similarly, Warehouse Reit has an estimated £100m of deployable funds before it hits its maximum LTV of 35% and has been busy buying after raising £45m in February, spending £35m on new properties in its first-half – although with some evidence in the form of a 4.6% initial yield that it’s having to pay more. It also spent £3.3m refurbishing existing properties, allowing it to extract higher rents from existing space, for example by adding mezzanines or developing adjacent land.

But they’re having to work harder to stand still. Continuing steady rental growth is likely to support continued returns to shareholders in the form of dividends and NAV growth, but most likely at a more sedate level than seen during the pandemic boom year. The sector still offers decent dividends yields of around 4%, even after its strong run, although investors will need to be wary that any further softening of sentiment – and thus, a contraction of premia – could offset them. The good times aren’t over, but the party seems to be winding down.

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