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Buy into property's industrial revolution

Forget Royal Mail - warehouses offer a higher-yielding play on the rise of online retail
October 3, 2013

The last time you bought a book from Amazon, chances are it came from Dunfermline, across the Firth of Forth from Edinburgh. This is where the e-commerce giant chose to locate its largest UK warehouse, which is the size of 14 football pitches. From there it was probably shipped to a central parcel hub in the Midlands, then on to a local goods yard before being posted through your door - all within 24 hours.

 

 

 

The property industry is often seen as a loser in the rise of e-commerce, which by definition does not require shops. Yet what is bad for shops should be good for the warehouses through which goods pass on their alternative way to consumers. Until now, most retailers have simply adapted their high-street supply chains to accommodate online orders. But this is clunky and often incapable of operating at the speed consumers now demand. Some forward-thinking property companies, notably industrial specialist Segro (SGRO) and the opportunist investment vehicle LondonMetric (LMP), are already positioning themselves to take advantage of the likely upheaval in retailers' supply chains.

 

Function, function, function

This trend is still in its infancy, but adds an intriguing gloss to the often-overlooked investment case for industrial property. It's important to understand why warehouses have traditionally been considered dowdy - why there are trophy homes, shops and offices, but not trophy warehouses.

Compare the flagship Primark store on Oxford Street with the same company's central distribution unit on the M1. For the landlord, the former is mainly a bet on the appreciating land value of a highly desirable location in very limited supply. For the latter, location matters less. Because the building does not need to be near customers or reflect the prestige of the occupier, the landlord's job is simply to provide efficient accommodation for a specific business need in a convenient place - which for national retailers usually means next to a motorway near the centre of the country.

This is why industrial assets are void-prone and invariably yield more than equivalent-quality offices or shops. Primark's distribution hub was bought by LondonMetric in March for £60.5m, giving a rental yield of 6.4 per cent even though the lease lasts until 2032 on unusually favourable terms to the landlord (fixed 1.5 per cent rental uplifts combined with upward-only rent reviews every five years). Multi-let trading estates yield considerably more than this. Oxford Street shops, on the other hand, can yield less than 4 per cent. Investors pay a premium for a top location because retailers will compete fiercely to rent it.

For some landlords, e-commerce may be changing this balance by bringing the industrial sector back into cities. Brokerage Jones Lang LaSalle forecasts rental growth of 1.2 per cent a year for multi-let London industrial estates over the next half decade, compared with just 0.2 per cent for the wider sector. "Rental growth prospects are greater in urban areas because there's more competition for land," explains head of industrial research Jon Sleeman. He cites the vast Park Royal estate in West London as an ideal location for so-called "urban logistics".

 

Hares versus tortoises

But the rise of online retail is not the only reason to invest in industrial property. The sector has always appealed to income investors, and there's no reason why this should change. The pure-play industrial shares detailed below all yield more than 4.5 per cent. The irony is that, for all their promise of growth, the prime retail and office sectors have long been outperformed by warehouses because of this superior rental yield. Including rents, £1,000 invested in warehouses in 1980 would have turned into £20,513 by the end of last year, says data provider IPD - compared with £19,184 for shops and just £12,383 for offices. Steady income beats sexy location in the long term.

A further advantage of industrial is its simplicity of construction, which makes it quicker and therefore less risky to develop. It takes at least three years to build a trophy skyscraper, by which time the cycle may have turned - that's why the Empire State Building in New York, Petronas Towers in Kuala Lumpur and Burj Khalifa in Dubai, to name but an infamous few, were all finished in the depths of a slump. It takes barely six months to build even a big warehouse, so it is much harder for developers to mess up.

Finally, the current economic recovery in the UK regions should reward industrial landlords. Shops and offices both face huge structural challenges: the rise of e-commerce for the former, a wave of lease expiries from the late 1980s for the latter. Many redundant commercial buildings will end up being converted into housing. Yet trading estates - particularly those with high vacancy rates of the kind owned by Hansteen (HSTN) - look set for a conventional cyclical recovery, boosting first occupancy and eventually rents.

Just as warehouses make useful income investments for institutional funds, industrial landlords make useful income investments for private investors. Hopes of economic recovery in Britain have buoyed shares in some companies to new post-crisis highs, but pockets of value remain. We give our verdict on the various players below.

 

 Market cap (£m)Share price (p)Book value (p)Premium / discountDividend yieldEarnings yield (forecast)Loan-to-value
Segro23123102945%4.8%5.5%44%
LondonMetric7571191099%5.9%4.2%43%
Workspace64344434827%2.2%3.1%40%
Hansteen639998516%4.7%5.3%42%
Raven Russia4247681-7%5.6%10.8%*45%
Mucklow26044030544%4.5%5.2%28%
Sirius Real Estate912641-36%nil8.7%65%

*Distributions via tender-offer buy backs

 

The good, the bad and the underrated

Segro is the most obvious way to gain exposure to the industrial sector. The largest industrial landlord on the London exchange by a huge margin, it used to invest mainly in multi-let industrial estates - it was founded in the 1920s to develop the Slough Trading Estate - but has since diversified into big single-let warehouses, "urban logistics" sites such as Park Royal (see above) and continental Europe. Its shares have rerated over the past 18 months as the company has reshaped a flabby portfolio and cut debt, yet they still come with a useful dividend yield and some recovery potential. At 310p, we upgrade our advice to buy.

LondonMetric is no pure play on industrial property, having been formed from the merger of London & Stamford, an opportunist investment fund, and Metric, a retail-park specialist. It has bought distribution sheds this year to boost its earnings and dividend cover after a series of major disposals - most notably Meadowhall shopping centre. We see no reason to change the advice articulated in our June tip (Buy, 115p, 6 Jun 2013). Buy.

Workspace (WKP) only operates in the London market, where the feverish competition for land has allowed it to turn old industrial estates into mixed-use centres with housing, offices and only a smattering of old-fashioned sheds. Its growth strategy is firing on all cylinders, but we recently downgraded our tip (Buy, 16 Aug, 252p) on valuation grounds. Hold.

Hansteen is a well-run vehicle with a rigorous value investment strategy - buy unloved regional trading estates on the cheap then cut rents to fill them up. It offers clear exposure to the UK's economic recovery, but the shares have raced up to a 16 per cent premium over historic book value. They remain attractive for long-term investors, but no longer offer value, so we downgrade our longstanding tip (Buy, 85p, 6 May 2011). Hold.

Aim-listed Raven Russia (RUS) is arguably the most compelling stock of the lot, offering both strong growth prospects and a valuation discount (see table). It has just finished building out a portfolio of exceptionally high-yielding logistics units around Moscow. Strong buy.

Birmingham-based family business Mucklow (MKLW) boasts easily the best long-term track record. It has proved a phenomenally competent and profitable operator over the years, and offers uncomplicated exposure to the UK's regional recovery. The problem is that investors have bid its tightly held shares up to a huge premium, which leaves no room for error and the shares may slip as the hunt for yield gradually abates. Take profits.

German industrial landlord Sirius Real Estate (SRE) offers a punt for the more speculative investor. With an excessive debt burden, it pays no dividends, but the shares could rocket if the company manages to refinance successfully. High-risk buy.