Mid-Year Review

Mid-year review 2023

In this month’s column, Colliers provide MHD with an in-depth analysis and mid year review on the industrial market.

Broader macroeconomic factors have provided the backdrop to market volatility for the commercial real estate sector in 2023. Ultimately, this has resulted in asset value write downs for some sectors, particularly those that aren’t able to offset yield decompression with rising rents.

While the industrial and logistics sector has not been immune to higher inflation, rising funding costs and slowing economic growth, it remains in a unique position as fundamentals remain solid. Much of the sector’s strength lies within the occupier market, supported by record low vacancy rates, significant levels of rental growth and a lack of uncommitted supply. While industrial yields have risen, the sector has the benefit of record levels of rental growth which has maintained asset values.

Rental growth showing no signs of abating

As we move to the middle of 2023, the sector’s performance has exceeded the expectations of many, and we are yet to see a slowdown in rental growth across most markets. At the same time, the wave of supply that was due to enter the market was expected to have a more material impact on vacancy rates, similar to what we are seeing in most US markets. However, the take-up of speculative facilities has been substantial, most of which has been expansionary space, and the commitment rate for facilities that will be delivered in 2023 already stands at close to 85 per cent, meaning the structural undersupply of warehouse space will persist. 

Globally, industrial rental growth has eased from the heights recorded in 2022 and has eventuated from more modest levels of demand and increased delivery of supply. In the US and UK, rental growth has fallen to high single digits, down from a high of ~25 per cent through parts of 2022. 

Australia has yet to see the same slowdown, and this stems from the high pre-commitment rates of new supply. In the US, 57.8 million sqm of stock is currently under construction, equivalent to 3.6 per cent of current stock. For Australia, warehouse space under construction represents 2.4 per cent of total stock, albeit with much higher pre-commitment rates – 20 per cent in the US compared to 74 per cent in Australia. As a result, there will remain fewer options for tenants in the Australian market, which will continue to fuel rental growth.

Looking ahead, rental growth for the balance of 2023 is forecast to remain elevated, with some markets predicted to record growth in excess of 30 per cent for the year, noting growth of ~20 per cent has already been recorded in select submarkets.

Modest rise in vacancy, yet remains close to all-time lows

Nationally, the industrial and logistics vacancy rate increased marginally to 0.8 per cent (up from 0.5 per cent in Q1 2023) and was underpinned by several speculative developments reaching completion and minor backfill options becoming available. However, globally, Australia remains one of the tightest markets and compares to the vacancy rate in the US at 4.0 per cent and the UK at 3.6 per cent.

In our view, the market equilibrium is in the order of 4.5 per cent, at which point rents tend to grow around their long-term average of ~3.5 per cent per annum. For the Australian market to get back to this level of vacancy, an additional 2.9 million square metres of vacant stock would need to become available on top of what is available today, which based on the uncommitted supply in the pipeline and lease expires where we know the tenant is vacating for 2023 and 2024, is not expected to occur.

Deal activity improving

Further increases in the cash rate and funding costs have continued to impact yields and liquidity within the sector, and asset pricing remains the key theme as buyers and vendors adjust to new market conditions. Nonetheless, transaction activity increased over the past quarter with almost $1.4 billion trading, up from $437.4 million in Q1 2023 ($1.8 billion YTD 2023). At the same point in 2022, $3.7 billion has traded, representing a fall of 54 per cent over the period. There is the potential that overall volumes could reach the levels recorded in 2022 as there is a significant volume of recapitalisation and portfolio opportunities in the market.

In the first half of the year, value add capital has been the most active in the market and is driven by these groups looking to reposition assets via rental reversions, refurbishment or redevelopment, including for multi-level facilities. Infill markets remain the primary focus, and 70 per cent of assets to trade in the first half of 2023 stemmed from such locations, up from 51 per cent in 2022 and 14 per cent back in 2020. Passive investors, particularly from the APAC region, have been more recently undertaking market and sector due diligence ahead of potential acquisitions and include portfolio and recapitalisation opportunities.

Industrial values hold strong amid economic headwinds

As attention is drawn to commercial real estate yields more broadly, it’s important to note rental growth’s impact on asset values in the industrial and logistics sector. In the absence of rental growth, the yield softening recorded to date would ordinarily result in a ~25 per cent reduction in asset values, comparable to recent transactions within the office sector. However, prime rents have increased by 40 per cent on average since yields began increasing, which has more than preserved asset values. The Australian industrial and logistics sector is unique in this respect, as other sectors are not seeing anywhere near the same level of income growth. 

The outlook for industrial and logistics yields is very much dependent on the path for inflation and interest rates. Based on the forecasts of the major Australian banks, there will be one additional cash rate rise in the second half of 2023, taking the terminal rate to 4.35 per cent. If this outcome proves true, it is likely that another 20-30 basis points of softening will occur for the sector, resulting in prime core yields in Sydney in the order of 4.75 per cent to 5.25 per cent. Rental growth will continue to mitigate this, and asset values are expected to grow modestly on average over the next six months

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