Should investors buy REITs that have exposure to the industrial property segment?
The industrial property sector has recovered well from the COVID-19 lockdowns. The warehousing and logistics segments have gained support from improved activity in manufacturing production, international trade and the domestic retail sector. According to Statistics South Africa, manufacturing production volumes increased by 1.4% year-on-year in August 2022, supported by vehicle and transport equipment production, which accounts for 9% of total manufacturing production. Between March 2022 and August 2022, the average annual increase in nominal manufacturing sales was 12%. At the same time, international trade’s need for storage, logistics and warehousing has provided solid support for industrial property owners. Additionally, growth in online sales, which was – to a large degree – bolstered by COVID-19 lockdowns, continues to contribute positively to the demand for logistics space as customers demand last-mile fulfilment. Retailers and logistics property companies have been adding warehousing and distribution capacity to optimise the supply chain. In 2020, South African online retail sales (ZAR30bn) contributed 2.8% to total retail sales, according to World Wide Worx. We think there is an immense potential upside for online retail sales in the long term.
Low vacancy rates bode well for rental growth
According to our calculations, based on company reports, the current industrial property sector vacancy rate is c 4%, slightly below the 25-year average of c 4.2%. MSCI reported that in December 2021, industrial distribution centres, industrial manufacturing and industrial warehouses posted vacancy rates of 0.9%, 7.7%, and 6.4%, respectively. This means that distribution centres outperformed other industrial property segments. Over the past few years, speculative developments in the industrial property space have been muted, despite the strong demand for industrial properties. Low vacancy rates augur well for rental growth as property owners do not experience negative rental reversions when leases expire.
Strong rental growth rates underpin valuations
According to property research company Rode & Associates, nominal rental growth for 500 sqm spaces rose by 5.4% year-on-year in Q222, a significant improvement compared to 0.5% and 2.2% in Q220 and Q221, respectively. Similar nominal rental growth of 5.3% was recorded in Q322; overall growth for the year so far has been 5.1%. The combination of positive nominal rental growth rates and declining capitalisation rates has underpinned the rise in industrial property values. However, Rode & Associates points out that real rental growth has been adversely affected by rising building cost inflation, which in Q222 was already 11% higher year-on-year, according to the Bureau of Economic Research Building Cost Index. Rental growth is a function of vacancy rate and construction cost inflation.
Big South African industrial property regions have shown impressive performance
The big South African regions have delivered strong nominal rental growth rates in 2022. Durban, KwaZulu Natal province’s biggest port city, was severely affected by floods and riots in 2021, which limited the supply of new industrial property stock. Nonetheless, demand for large-scale industrial properties remains strong, especially in the logistics sector. According to Rode & Associates, in the year to end September 2022, nominal rental growth was 5% year-on-year, significantly higher than the 2% growth in the previous year. In Cape Town, Western Cape province, nominal rental growth increased by 6.7% year-on-year in Q322, marginally below the 7.2% posted in Q222. Lastly, in Witwatersrand, Gauteng province, nominal rental growth was 4.4% year-on-year in Q322. Looking ahead, a major deceleration in rental growth seems unlikely given the limited supply of new stock in big metropolitan areas.
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