The tide is going out on listed property’s most popular sector

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Residential property has most Australians in thrall. Popular TV shows feature stressed renovators and hot auctions. Get rich quick while taking on significant mortgages is a common mantra of property spruikers.

In the listed space the hot sector has been industrial property.  Fairly non-descript warehouses have taken over the mantle from formerly popular destination-based major shopping centres and well-located city offices.

Many warehouse tenants are retailers, not only for storing inventory to deliver to their stores but also for servicing their growing online offers. Online only retailers such as Amazon have also bolstered demand. Wholesalers such as Metcash and medical equipment or industrial product distributors also require warehouse space.

Covid gave the sector a big leg-up. Recurring lock downs accelerated the shift to online ordering and delivery with stores closed or people fearful of going out to shop. Furthermore, with a surge in demand fed by government support payments, zero interest rates, and a reallocation of travel spend, not to mention toilet-papergate and other hoarding, existing warehouse space seemed inadequate. Even as we emerged from Covid, demand remained strong and supply chains took time to accommodate the hot demand. Retailers hate being out of stock as you cannot sell something you don’t have, and a shortage of parts plays havoc with manufacturing processes.

The conditions were perfect for a squeeze on warehouse space, resulting in extremely low vacancy and rents that doubled in a short space of time.  The shares of industrial property plays such as Goodman Group soared, while retail and office landlords have been marked down.

However, the days of heady demand, for now at least, appear to be over. The consumer, after burning through savings and being forced to convert ultra-low fixed rate mortgages to higher variable rate mortgages, is finally showing signs of belt tightening. At the same time retailers are more confident that their supply chains can cope, and they do not need to hold as much safety inventory. Many retailers are reporting slowing sales, with downbeat updates in the past two months from Baby Bunting, Kathmandu, Super Cheap, The Good Guys and others.

In Sydney, according to CBRE’s latest sector report industrial vacancy rates have increased from 0.5% to 2%. This has been predominately driven by an increase in sub lease space, as retailers realise that they overcommitted to new lease space, which now costs twice the rent it once did. It’s important to note that retailers typically only earn single digit profit margins, so this additional cost burden is material. The timing for retailers couldn’t be worse with margins under pressure from a normalisation of promotional discounts and general wage inflation. Predictably, higher vacancy and competition from new sub lease space has put pressure on face rents and incentive levels for new tenants. According to a recent CLSA note to clients, incentive levels in Sydney and Melbourne have risen from 5% to 20%, a clear signal that demand for new developments has turned south.

While Goodman at its first half results reported a rise in cap rates from 4.5 to 5.1% (higher cap rates mean a lower multiple of face rents is being used to value properties), this is still a historically low level implying high valuations remain in place. Goodman is a market darling because of its data centre pipeline but this equates to less than half of the development book. For the large proportion of Goodman’s substantial development book and for other property companies that have been shifting their focus to the very popular industrial sector, rising vacancies and falling rents is not what the doctor would have ordered. The progress of an optimistic boom is normally toward an inevitable bust. With lots of new capital entering the industrial market just as conditions are turning, this points to a cyclical story as old as time.

Article by Hugh Giddy. Hugh is a Portfolio Manager for IML’s Concentrated Australian Share Fund.

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