The UK real estate market has faced unprecedented uncertainty in recent years. First, the Brexit referendum led to political turmoil, protracted and wavering negotiations with the EU and fears of major disruption to trade and economic growth. Then, in 2020, the COVID-19 pandemic struck. The UK economy, like most across the world, shrunk by 25% as per the Financial Times over the course of three months as the UK entered into lockdown to lower the spread of the virus and businesses closed — some permanently. Despite, these challenges, however, some property sectors have not only survived, but thrived. The UK property market faces a wide range of potential headwinds and tailwinds but, LISA CARSE opines, there are attractive opportunities that are ripe for the picking by investors who know where to look.
Logistics is a bright spot
Arguably, one of the bright spots during these dark times has been logistics. The sector has shown resilience both historically and currently during the pandemic. For example, during the 2008 global financial crisis, logistics real estate continued to produce attractive income returns, even when capital growth turned negative.
UK logistics real estate has generated strong income returns and capital growth through market cycles. Over the past 10 years, the sector has achieved total returns of 12.4% per annum on an unleveraged basis before considering accretive financing. Looking toward the future, total returns are forecasted to reach 6.9% per annum through 2024 in pound sterling (GBP) terms on an unleveraged basis. The GBP terms are key in that the sterling is anticipated to appreciate vs. most other currencies due to the current low exchange rate, a fact that will further enhance returns.
In addition, market fundamentals for UK logistics are attractive with limited supply and low vacancy rates of around 6.9% with a supply of 37.3 million square feet. At the same time, historical trends highlight that when the vacancy rate is below 12%, the market experiences rental growth.
In fact, UK logistics market rents, including Islamic leasing, have increased by around 25% since 2010, and rental growth was not affected by the Brexit referendum and resulting uncertainty. Rents are projected to continue to grow around 2.5% per year through 2024, according to the Knight Frank UK Logistics Market Dashboard of April 2020.
Logistics has withstood the effects of the global pandemic
Government-imposed restrictions on non-essential movement and the people’s mobility in the UK during the pandemic had a huge impact on the entire economy. People could not leave their homes, retailers had to close their doors and economic activity slumped. While the full extent of the crisis’s economic impact is yet to be determined, if the pandemic results in a recession, it would be expected that the negative impact would be felt on all real estate through reduced leasing activity, including Islamic leasing, high vacancy rates and falling rents. However, early indications suggest that UK logistics real estate is one of the best positioned property types to withstand the impact of the pandemic.
The lockdown imposed in the UK necessitated the strengthening of e-commerce retailers and supply chains, as people could not visit brick-and-mortar stores as normal to buy essentials. The growth of online sales surged between 20% and 40% year-on-year in March and April, according to Savills Research and IMRG Capgemini. This brought about an increasing demand for warehouse space after the pandemic lockdown in the UK as firms focused on strengthening supply chains and managing their inventories to support the ‘stay at home’ economy. This move to online sales during the lockdown only accelerated a trend that was already in place where retail e-commerce sales grew from less than 5% of total retail sales in 2008 to 24% in 2020.
In addition, a study conducted by Azimuth Global Partners of rent collection rates reported by leading UK REITs is telling. It shows that industrial/logistics properties were able to collect rents at higher rates than office, retail and other diversified property types in the first quarter of 2020 while the country was in the midst of the pandemic and lockdown. This means that companies leasing industrial/logistics assets had more capacity to pay their rent on time and in full, which would imply that they were not as impacted by the pandemic and lockdown.
Shariah compliance in logistics
Commercial real estate investment is attractive to Islamic investors as it is asset-based and relies on an income stream from cash-generating assets. Investments into real estate must be screened to ensure that they have underlying assets and business activities that are Shariah compliant.
However, ensuring Shariah compliance can be tricky for certain asset types, especially when these assets are located overseas. For example, an office building in the UK might have a tenant that engages in Shariah compliant business activities, so no problem there.
However, that same building might have a ground floor restaurant that serves food and beverages that are not Shariah compliant, so therefore, the entire asset might be compromised if the proportion of rental income or floor area that is dedicated to the Shariah non-compliant activity exceeds a certain permissible threshold.
At the very fundamental level, the principal activity of a logistics facility is to support the movement and distribution of physical goods, be it raw materials, fast-moving consumer goods or consumer durables, from the source to end customers. In this sense, the use and underlying activity of the logistics assets are Shariah compliant but it is important to screen for assets with tenants involved in the distribution of Haram goods, for example, alcohol, tobacco and weapons. The other aspect of ensuring the Shariah compliance of a logistics real estate asset is in the structuring, including ensuring the moderate use of financial leverage and financial products that are in accordance with Shariah principles.
For investors, the process of identifying, evaluating and investing in Shariah compliant logistics assets is relatively more straightforward compared to other sectors, as a huge proportion of the logistics assets are single-let, with long leases to creditworthy tenants. In addition, the UK has robust and well-developed Shariah compliant financing readily available for investors.
Investing in UK logistics funds minimizes risk
While UK logistics represents an opportunity for investors, expert knowledge of the market, the characteristics of locations and whether each individual asset is Shariah compliant are key factors to be considered. For the uninitiated, an investment in a single asset with a single tenant exposes the investor to a myriad of risks that must be studied, evaluated, and if needed, mitigated, especially during uncertain times. Rather than invest in a single asset and hope that the tenant does not go bust, investing in a fund that mitigates a variety of risks by pooling assets could be a smart strategic move.
Investing in core logistics assets in the UK which are carefully selected by experts could be an opportunity ready to be seized. These assets would be located in primary UK distribution markets and with strong tenants that are signed onto longer leases. These types of longer-term investments have the potential to deliver attractive income returns for value investors. Funds can also have investment strategies in place to select certain types of assets that may not be directly accessible to investors such as forward-funding opportunities that are pre-let to strong credit tenants.
Many institutional investors will not directly take on forward-funding or forward-commit investments because of the risk, while a fund can be selective in ensuring that these types of opportunities are properly vetted so that risks are minimized. To ensure Shariah compliance, the investment would be under an Ijarah contract, where the fund would acquire the assets and then lease the assets to tenants. Income to investors would be generated from the rental received from tenants. Upon maturity, the fund has the option to sell the assets and realize the capital.
An additional and very important point to note is that logistics cuts across industries. Think about the goods you consume and consider whether they had to be warehoused at some point while waiting to be distributed to retailers or directly to end consumers. Almost all types of industries require warehouses and distribution centers, so logistics as a sector is less exposed to the ups and downs that any individual industry, be it food, beauty, construction, etc, might be facing.
UK logistics is a compelling proposition
Given the uncertainty in the global market and the fact that most countries have slipped into recession due to the pandemic, many investors are taking a wait-and-see approach. The pandemic is constantly evolving with different countries passing through different phases with varying success. Some are even moving backwards, possibly back toward lockdowns after having opened up to ensure some level of economic stability.
Yet despite this still-evolving threat, we would argue that UK logistics is a compelling proposition due to its historical resilience and the rise of e-commerce accelerated by the UK government’s restrictions on non-essential business and the people’s movement. Combine this with low vacancy rates, rising rental rates and limited supply, and the proposition starts to look very attractive indeed.
Lisa Carse is the senior director at Azimuth Global Partners. She can be contacted at lisa.carse@azimuth-jersey.co.uk.
Disclaimer: This article was first published in IslamicFinance news Volume 17 Issue 29 dated the 22nd July 2020.
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