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What price flexibility?

Rising inflation, falling growth, European war… It all adds up to reasons to stay flexible, and that applies to warehouse leasing deals, as David Thame reports.

Once upon a time, if you signed up for a new warehouse you were committed for the rest of your working life.

That’s because until the Noughties, new warehouse leases were normally 25 years, and a lot can happen in 25 years. Today, flexibility and shorter-term leasing has won out. Warehouse leases are regarded as super-sized and gold-plated if they have a 15-year expiry, but even here the deal includes break clauses at year three, five or ten.

But we could be on the brink of yet another reduction in average lease length, thanks to the combined effects of rising inflation, the risk of recession and the untold complexities of a European war. Last week the governor of the Bank of England, Andrew Bailey made it clear how much danger the UK economy faces, thanks to its high exposure to the effect of rising fuel prices.

It does not take much imagination to see how a dip in consumer spending could quickly turn a cost-of-living crisis into a recession. If that happens then all the sunny predictions about online retail could begin to turn cloudy, and warehouse operators risk having too much expensively-fitted out warehousing floorspace on their hands.

So, what gives? At times of crisis, nobody likes to commit themselves. So the consequence could be that warehouse occupiers push for shorter, more flexible leases. Or will it? Some property experts have their doubts.

Laurence Davies, a specialist in Cushman & Wakefield's national logistics and industrial team, explains: "A slowdown in consumer spending will inevitably have an impact on how online retailers manage stock levels. Greater lease flexibility could become an increasingly important factor and much like the majority of 3PL operators, occupiers are likely to look at a more flexible lease structure, closer to the 5 yearly break model or possibly even shorter.”

“With warehouse supply at an all-time low and demand still strong in most UK markets, landlords are unlikely to be open to offering more regular breaks, where longer term leases have become market standard in the big box sector.”

Yet Davies suspects that in some markets, and for some occupiers, serious glitches in the global supply chain will mean business as usual for warehouse property. For so long as retailers and distributors feel the need to stockpile, demand for warehousing will hold up, he says.

“Interestingly, we are working with several online retailers who are seeing a less aggressive fall off in demand but have greater concerns around supply,” he says. “China’s strict COVID lockdowns have created lengthy manufacturing disruptions, which has resulted in firms struggling to fulfil their order books and has left customer demand unsatisfied. This trend has meant that occupiers are stockpiling products to combat any future supply chain issues, which has subsequently increased the space required in the short terms for many of these businesses.”

Of course, these supply chain issues will ease at some point. China is already edging cautiously away from its zero-covid policy in the face of mounting economic costs.

Says Davies: “These conflicting agendas [the pressure for shorter leases and the need to stockpile] may cause caution among online retailers in the future, but for now, many of these businesses are still seeing demand outstripping supply. This market dynamic bodes well for the logistics sector in the short term and with occupier demand still strong and limited stock levels, we expect to see another strong year for the sector."

So much for current supply chain trends – because behind the storm and stress of today’s economy sits the long-term trend towards shorter more flexible leases. Many close observers see no reason why this trend should abate, and plenty of reasons why it might speed up.

James Goode is a director within Avison Young’s industrial team. He says: “Occupiers have always preferred as much flexibility as possible, so this is nothing new. However, we are not seeing shorter leases being signed on Grade A buildings due to the lack of supply in the market. Landlords know that they have the ability to hold out for longer leases simply because the demand is there.”

“There is the odd exception,” Goode confesses, “but generally anything less than a ten year term is only available on a more secondary building, a building with issues or where the landlord has a wider relationship with the tenant.”

 The background, of course, is a UK warehouse property market with very little slack. What good vacant floorspace there is soon finds a tenant. Newly built space often pre-lets before the completion of building work and although speculative development is on the way, this takes time. It’s not going to solve the supply crisis today, or even this year.

Research from surveyors Gerald Eve shows that some top rents were almost 60% higher in the first quarter of 2022 than they were at the end of 2020 while the empty of empty (void) floorspace was at or near historic lows.

Many occupiers have yet to feel the effect of this surge in rents – although they can’t escape it for long.

Gerald Eve points to an epidemic of “under-rentedness” – meaning that the rent currently being paid by occupiers is now someway below the rent the landlord could get on the open market.

In some cases the gap is wide and growing, with a shortfall between contracted and estimated market rents of 8% in the regions and 20% in London and the South East, at the end of 2021. Some occupiers in multi-let premises (e.g. smaller industrial estates) are now typically paying rents that are more than 30% below the market rate, through a combination of under-rentedness and rental incentives.

This is great for tenants enjoying good floorspace at unusually low rents – and for those in this lucky position, the temptation to shed floorspace shorten leases, or move at all, will be limited. Why should they? They have a brilliant deal.

But Gerald Even warns that the gap between market rents and the rents some occupiers are tied to may prove problematic for some occupiers when rents are reviewed and new leases signed over the coming months and years, and given the economic storm clouds the increase in property costs will come at just the worst possible moment.

Ben Clarke, Partner at Gerald Eve, explains: “While multi-let industrial has seen a stellar performance over the last year, we should be mindful that there’s been sustained business support from the government and SMEs have taken on a substantial amount of extra debt.”

Some of these lucky occupiers – soon to face a chilling downpour of economic reality in the form of rising rents – are already facing financial perils.

Says Clarke: “The UK company insolvency rate, which is typically highly correlated with the multi-let default rate, has been trending sharply upwards on more recent, higher frequency measures, which is a potential warning sign of things to come.”

These unfortunate cases aside, the warehouse sector is still – just about – looking robust. But for some occupiers some tough decisions on new premises, new rents and new leases, will be unavoidable.

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