Rise of the New Sectoralism

Revitalised sectors:

Just over a decade or so ago, real estate developers and investors alike were still planning, modelling and operating with sectoral categories that had changed little over several decades: broad sectors of ‘office’, ‘retail’ and ‘industrial’. The then Investment Property Databank (IPD) indices tracked and benchmarked these broad sectors internationally^[1]. Even residential was sidelined, let alone subdivided. REITs were probably the first institutional investment vehicles to break free of these constraints, taking advantage of the significant liquidity of public markets in the US in particular to deploy specialised investment opportunities at the retail level. Real estate investors in OECD markets rapidly took it for granted that their portfolios could be built on diversification or specialisation in multifamily housing, student accommodation, self-storage or even prisons^[2].

More recently, what the market now calls Industry 4.0, smart warehousing in particular has been extensively promoted as a growth opportunity in OECD markets. Warehousing as a whole has mostly performed well, albeit in many cases with compressed yields, but as MSCI pointed out, industrial outperformance has been, for several years now, the most pronounced in countries such as the UK, where e-commerce penetration is particularly strong^[3]. The current value narrative, reflected in both the business and academic literature, is that certain elements are, however, widely recognised as required to make a warehouse genuinely smart.

The role of the Internet of Things (IoT) – for example^[4], in most distribution centres, guided vehicles can only move on aisles using QR codes, but the utilisation of space is not efficient enough. Automated, intelligent systems can reduce space as well as save time, besides also linking to automated billing systems^[5]. The ability to handle Big Data, for another: what is needed is a scalable, high-performance, flexible and adaptive storage and processing system, capable of dealing with the ever-increasing volume, variety, and velocity of data^[6]. Physically, the necessary real estate involves a much higher floor-loading capacity than a traditional warehouse, as well as a higher electrical loading and fibre optic or fast wireless infrastructure. Evidently, the bar is set quite high for what can pass as a smart warehouse and hence existing supply is still small, especially in the Gulf, including the UAE. By comparison, for example, China already had 3000 smart warehouses in 2016, and investment is currently growing at a high double-digit number annually. Industry 4.0 also needs smart factories^[7], which will frequently require either greenfield development or complete refurbishment of existing facilities – another similar opportunity.

Focused residential property is the second group of sectors that has already been sought by investors in OECD markets. Pure play REITs in manufactured housing – an attractive possible future for construction accommodation in the UAE – as well as ‘senior living’ and student housing have outperformed the sector as a whole in the USA during the past year by approximately 18%-10%, at least if outliers are excluded from the comparison^[8].The beginning of investment in this sector in the UAE has already been observed with the initiatives of Dubai Healthcare City, but there is evidently a long way to go. But to this can be added specialised real estate, for example, data centres and cell towers, both of which have formed the basis for REITs in markets that are broad enough to encompass them.

The new sectoralism therefore implies that the traditional real estate sectors, including residential and industrial, are no longer fit for purpose in the majority of international markets. If the evidence from REITs in developed markets is a guide, investors in the UAE now need to be more discriminating, and to insist that their advisers provide them with more granular data and guidance.

What does the data already tell us?

Data from Property Monitor very much supports this analysis, albeit that index data is necessarily at a higher level of granularity. While a sizeable office development in Dubai Marina, for example, might currently be expected to achieve around AED 1000/sq ft to 1200/sq ft, or a small office in Business Bay, anywhere between AED 500/sq ft and AED 850/sq ft, the evidence is that these numbers have declined over the past two years – stabilising for hedonic variables such as size, precise location and build quality, around 10-20% annually. While these are considerable declines, they must of course be placed in the context of cyclical value growth in previous years, and optimists might well suggest that the cycle is due for a turn after the next couple of years.

But the attractiveness of warehouse investments by comparison is stark. On average, investments in Dubai Investments Park, for instance, have generated hedonic stabilised rent increases of around 25% annually, at least until this year, when the effects of the pipeline have stabilised, if not reduced achieved rents. This comparatively superior performance has come concurrently with longer leases and fewer delinquencies, although admittedly, this particular advantage may well reduce in the face of tech leverage and market pressure. Similar, if not better performance, has been observed in Abu Dhabi, Oman and elsewhere in the region. The reason is not hard to see. The volume of transactions is indicative. While office transactions are measured in the hundreds, warehousing transactions stand at an order of magnitude less, while specialised residential transactions are yet to arrive in the UAE market.

When the qualitative issue of smart warehousing is introduced as well, for example, early compliance with the Dubai Customs smart system^[9], comparative performance is better still. What is of special note is that, considering total return valuations, examining specific comparison pairs of properties in comparably zoned areas as there is insufficient data for indices, the gap between the performance of direct high-end warehousing in the UAE and the warehouse sector overall closely parallels that of the US and Germany, where integration with supply chains is at a greater level of development. This should not come as a surprise: real estate markets, as was seen with the UAE’s residential market a decade ago, are, along with other asset classes, leading indicators of economic development^[10].

Conclusion: what strategy to follow?

It is inevitable that when a new investment sector opens up, or an existing one acquires new reasons to become attractive, investors are faced with a difficult choice. With supply of existing warehousing and specialist property stock low by definition, combined with the fact that in the UAE, there are as yet no publicly traded real estate vehicles specialising in individual markets, their only route to reaping the higher returns that are available in these sectors is to engage in construction.

A construction plan that combines

• following the projected returns of successful REITs in OECD markets (Prologis for industrial^[11] and HCP healthcare REITs in the US are examples),
• analysis of the rate at which the UAE is catching up in areas such as market integration and mobility, the structure of Foreign Direct Investment (FDI) into the UAE, and demand from service providers; eg, for continuing care retirement communities, and
• recognition of the opportunities potentially created by financial innovation, whether straightforward short-term leases, sale-and-leaseback, or tranching

strikes me as a low-risk approach to the new sectoralism in the UAE. It will be data heavy. It must also take into account politics and geography at everything from a regional to local level, but it surely makes more sense than insisting on no change in strategy, ignoring the lessons of supply and demand. The big question though is scale: how much demand for this superior real estate actually is there? I will address this question in a later post.

[1] See IPD Index Guide Edition 8. (2012) Available at: http://ec.europa.eu/finance/consultations/2012/benchmarks/docs/contributions/individual-others/ipd-annex1_en.pdf Retrieved 23 March 2019.

[2] Deloitte (2013) Non-traditional real estate. Capitalizing on the REIT opportunity. Available at: https://www2.deloitte.com/lu/en/pages/real-estae/articles/real-estate-investment-trust.html Retrieved 20 March 2019.

[3] See Nihilani, A. (2018) Industrial in the Limelight:  Secular Shift or Cyclical Rotation. MSCI. July 2018. Available at:  https://www.msci.com/documents/10199/22be8901-bff0-8a61-29bd-2c2c0706bf56 Retrieved 28 August 2018.

[4] See Mostafa, N., Hamdy, W. and Alawady, H. (2019). Impacts of Internet of Things on Supply Chains: A Framework for Warehousing. Social Sciences, 8(3), p.84. Available at: https://www.mdpi.com/2076-0760/8/3/84/pdf Retrieved 22 March 2019.

[5] See Lee, C.K.M.(2018) Development of an Industrial Internet of Things (IIoT) based Smart Robotic Warehouse Management System. Association for Information Systems AIS Electronic Library (AISeL) CONF-IRM 2018 Proceedings. Available at: https://aisel.aisnet.org/cgi/viewcontent.cgi?article=1034&amp=&context=confirm2018&amp=&sei-redir=1&referer=https%253A%252F%252Fscholar.google.com.au%252Fscholar%253Fas_ylo%253D2018%2526q%253Dsmart%252Bwarehousing%2526hl%253Den%2526as_sdt%253D0%252C5#search=%22smart%20warehousing%22 Retrieved 23 March 2019.

[6] See Costa C., Andrade C., Santos M.Y. (2018) Big Data Warehouses for Smart Industries. In: Sakr S., Zomaya A. (eds) Encyclopedia of Big Data Technologies. Springer, Cham. Available at: https://link.springer.com/referenceworkentry/10.1007%2F978-3-319-63962-8_204-1#howtocite Retrieved 22 March 2019.

[7] IoT Analytics (2019) Available at: https://iot-analytics.com/the-leading-industry-4-0-companies-2019/ Retrieved 22 March 2019.

[8] Motif (2019) PPA: Specialized REITs. Available at: https://www.motif.com/motifs/ppa-specialized-reits-I0tsas47 Retrieved 22 March 2019.

[9] See Dubai Trade (2017) Dubai Trade launches LogiGate smart app for land transportation and warehousing. Available at:  http://www.dubaitrade.ae/media-centre/media-outlook/2591-dubai-trade-launches-logigate-smart-app-for-land-transportation-and-warehousing Retrieved 23 March 2019.

[10] See Plakandaras, V., Cunado, J., Gupta, R., and Wohar, M.E. (2017) Do leading indicators forecast U.S. recessions? A nonlinear re-evaluation using historical data. International Finance, 20(3), 289–316

[11] See Keenan, C. (2019) REIT Warehouse Logistics Being Redefined by Prologis. REIT magazine [on line] 28 January 2019. Available at:  https://www.reit.com/news/reit-magazine/january-february-2019/reit-warehouse-logistics-being-redefined-prologis Retrieved 23 March 2019.