June 2016

Trade trends and the impact on industrial real estate Capital Markets Research

Trade trends and the impact on industrial real estate Industrial accommodation in South Africa has seen a transition over the past few years, driven by various factors that have contributed to some changes in the South African economy. This report provides analysis of the major contributing factors to the key drivers of industrial property developments over the past ten years, and the implications these have had on the industrial real estate sector. The prevailing economic conditions are examined to draw an outlook on development activity in the sector. Large supplies of natural resources and the considerable pull of an unskilled to semi-skilled labour force defined the structure of the South African economy in the past. Agriculture and mining contributed to the growth of the industrial sector in South Africa, which established the historical industrial nodes of the country. However, over the years, tertiary sectors have grown, contributing to the adjustment of the country’s economic make up.

Figure 1: Contribution to GDP by sector: 1996, 2005, 2010, 2015 2015 2010 2005

In 1996, agriculture and mining made a combined contribution of 18.0% to the Gross Domestic Product (GDP) according to Statistics South Africa. This declined to 15.0% in 2005, 12.0% in 2010 and to 11.0% in 2015, with mining and agriculture playing a smaller role in the overall GDP make-up of the economy. Similarly, manufacturing has declined from a contribution of 16.0% in 1996 to 14.0% in recent years. The decline of the primary sectors (agriculture and mining) which provide inputs to the secondary sector (manufacturing) is of significance. It is an indication that the economy is not engaged in the same levels of hard manufacturing which had previously been the case.

7% 9%

29%

Contribution to GDP by sector

9%

15%

12%

11%

18%

14%

9%

The decline of the manufacturing sector is evident in the shutdown of manufacturing plants over the years. A typical example would be the textiles and clothing sector that has seen factory numbers more than halving since 1996. Despite the periodical peaks and troughs, manufacturing capacity utilisation has declined from an average of 86.0% in 2005-2008 to 80.0% in 2013-2015. Employment in the manufacturing sector has also declined from a total of 2.1 million jobs in 2008 to 1.7 million in 2015, pointing to a smaller manufacturing sector than indicated by the sector’s GDP contribution.

29% 27% 29%

1996

22% 21% 19% 16%

14%

16%

15%

14%

15%

14%

15% Other

Wholesale, retail and motor trade, hospitality

Primary sectors

Logistics (transport, storage, communications)

Manufacturing

Finance, real estate, business services

3,319 3,126 3,280

Figure 2: Employment (Stats SA QLFS) 3,500

500 Agriculture

Mining

Manufacturing

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Utilities

Construction

Trade

Transport

2015

2008 Finance

2010

1,780 1,700 2,273

102 96 123

1,000

353 321 483

1,500

808 805 900

2,000

1,181 1,115 1,438

2,111 1,889 1,738

2,500

838 649 860

’000 employed

3,000

Figure 3: Annual sales growth average (2008-2015 constant prices) 6.0

4.9%

5.0

%

4.0

3.8%

3.2%

3.1%

2.9%

3.0 2.0 1.0 0.0

0.9%

0.5% General dealers

Food & Pharmaceutical, Textiles, beverage cosmetics, & clothing, & toiletries footwear

There is no doubt that manufacturing has stagnated in the country, contributing to a decline in the factory capacity utilisation and the shutdown of some production plants. This has contributed to the decline in demand for certain types of industrial real estate, and depressions in hard manufacturing towns. Subsequently, this has had an impact on the industrial real estate market and the type of deals one is seeing in the market. A prime example is the 2014 MacSteel sale and leaseback of properties to Redefine. The transaction was largely aimed at improving the MacSteel balance sheet following months of declining demand for steel products in the global market. In a similar fashion, construction company Aveng sold office and manufacturing properties worth US$81 million to Collins Group in 2015, but retained warehousing space in Jet Park, Boksburg. Yet there is no doubt that the South African economy is still seeing pockets of growth, even if that growth has seen a notable slowdown in recent years. Growth is propelled by rising earnings, an expanding population which is driving consumption, and the establishment of different sectors seen in the strong growth

Furniture, appliances & equipment

Hardware, paint & glass

All other retailers

of the construction and financial sector, business services, and trade. This relates to commercial real estate in light of the growing demand for office accommodation on one hand and the rising demand for retail and light industrial accommodation on the other. As the centres of production have changed, so have employment and earnings in the economy. The financial, trade and construction sectors have seen the strongest growth in employment over recent years, while employment in manufacturing has maintained a downward trend, and employment in the primary sectors has stagnated. The result is that the economy has seen a structural shift towards a more skilled labour force, contributing to a higher earning potential and an increased standard of living. This results in a change in the types of goods and services that consumers spend their money on. Along with the ongoing demand for essential goods such as food, South Africans are showing increased demand for pharmaceutical and cosmetic goods, as well as clothing and footwear. These two retail segments have seen the fastest growth in the past seven years at 3.8% and 4.9% respectively.

Figure 4: Retail sales composition: 2008 & 2015 2015 2008 12%

40%

39% 13%

10% 8% 8%

6%

9% 5%

5% 18%

7%

20%

General dealers Food & beverage Pharmaceutical, cosmetics & toiletries Textiles, clothing & footwear Furniture, appliances & equipment Hardware, paint & glass All other retailers

In addition, the rise in demand for international brands has seen global retailers showing an increased interest in opening retail stores in South Africa. All of the above have increased demand for logistics and warehousing activity in South Africa, supported by resilient retail and wholesale trade sales. Hence the GDP growth rate in logistics compared to the trade sector is similarly aligned at an average 3.1% y/y over the past 10 years.

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Trade trends

Following the economic recession of 2009, retail and wholesale trade sales at constant prices have achieved a 4.0% y/y growth average (2011-2015) well above the overall GDP growth rate of the country. Trade has significantly carried the South African economy with consumption accounting for more than 61.0% of GDP. A significant portion of this consumption is driven by imported goods and one could argue that imports activity has grown faster than South Africa’s infrastructure can keep up with, leading to the geographical sprouting of light industrial accommodation, increased truck utilisation and the growing importance of national road networks. This has had a significant impact on the specifications of light industrial developments of late.

Figure 5: 10 year average GDP growth (constant prices) 7.0

6.1%

6.0 5.0

%

4.1%

4.0

3.2%

3.0 2.0

0.8%

1.0 0.0

Finance, real estate, business services

Transport, storage & communication

Wholesale, retail, motor trade, catering & accommodation

Construction

Manufacturing

Electricity, gas, water

-0.3% Mining & quarrying

-1.0

Figure 6: Annual growth: retail sales (constant prices), wholesale trade sales (constant prices) and import volumes 25.0 20.0 15.0 10.0 5.0

%

0 -5.0 -10.0 -15.0 -20.0

2005

Retail trade

2006

2007

2008

Wholesale trade

2009

2010

2011

Imports (volumes)

Data: Statistics South Africa, South African Reserve Bank

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3.1%

1.9%

1.6%

Agriculture, forestry & fishing

In a closed economy, the relationship between growing GDP, employment and earnings would traditionally contribute to a rise in manufacturing, as the demand for goods and services increases. Nevertheless with the option of international trade, the South African economy has seen the rise in imported goods with competitive prices and product preferences contributing to consumer behaviour. In the time that the primary and manufacturing sectors have seen a declining role in the economic make up of South Africa, imports have come to play a greater role. Although partly explained by the depreciation in the Rand, the South African trade deficit has increased from R4.2 billion in 2005 to over R70.0 billion in just ten years. The inflow of final goods, most being consumer goods, has contributed to the increased demand for storage, logistics and warehousing services in the country, and a clear correlation is visible in the trend of wholesale and retail trade sales in comparison to imports.

2012

2013

2014

2015

Light industrial accommodation takes over

1600000 1400000 1200000 1000000 800000 600000 400000 200000 0

2004

2005

2006

Shopping accommodation

2007

2008

2009

2010

2011

2012

2013

2014

2015

Industrial & wholesale space

Figure 8: 10 year growth in industrial completions 60.0 53.0% 50.0

45.7%

40.0

34.9% 29.5%

30.0

25.3% 20.1%

Limpopo

Mpumalanga

8.7%

North West

Free State

Northern Cape

0.0

11.0% 6.0%

Eastern Cape

10.0

Gauteng

20.0

KwaZulu-Natal

%

Western Cape

It is interesting to note that while additions to retail accommodation have flattened out to an average of 500,000m2 a year since 2010, the industrial sector has seen an underlying upward trend in developments. The flattening in retail developments may be attributed to the growth in online retail which is a small but growing segment of the market. On the other hand, the upward trend in the industrial sector is partly attributable to the increasing development activity in previously underserviced provinces. The Eastern Cape, Northern Cape, North West, Mpumalanga and Limpopo have all seen double digit growth in industrial accommodation over the past ten years, highlighting the growth of logistics and distribution activity across the country. This also provides an indication of the increased use of South Africa’s road networks, as trucks are extensively used in the transportation of goods across the country.

Figure 7: Completed developments

sqm

In just ten years (2005-2015) South Africa has seen a total of 11.9 million square metres of industrial and warehousing accommodation developments come to completion (Statistics South Africa). This compares to 8.1 million square metres for retail accommodation. Figure 7 shows the trend of industrial developments in comparison to retail developments, with the asset classes showing a correlation indicative of the link between the two. Overall, Gauteng accounts for 38.0% of completed industrial developments, which have been dominated by warehousing and logistics. This is followed by the Western Cape at a 27.0% share and KwaZuluNatal at a 19.0% share of total industrial developments. It is not surprising that these are the provinces with the largest cities in South Africa, hosting the majority of the population and its spending power.

Data: Statistics South Africa

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In line with the changing scope of what industrial accommodation is now used for, property developers have seen a notable change in the kind of specification occupants seek. Given the prevailing economic climate, developers have begun to avoid speculative developments, limiting these to mini units which are attractive to small to medium sized enterprises. In contrast, large developments are non-speculative in nature which allows for occupiers to have some input on building specifications. Zenprop and Growthpoint have shown similar sentiments with regard to the use of new buildings. Both have seen minimal hard industrial developments over the past few years, and the few that do happen are often owner occupied on completion. Stephen Standfest, Head of Industrial Developments at Zenprop, highlights that Zenprop has seen pharmaceuticals, food and clothing companies carrying the light industrial market and that the majority of developments are occupied by importing companies. Similarly, all of Growthpoint’s new industrial developments have been warehousing and logistics related. Engelbert Binedell, Divisional Director – Industrial, Growthpoint, adds that an estimated 90.0% of their developments are related to imports activity. With this change, development specifications have also changed for industrial occupants. Historically, industrial buildings required larger office components and needed to host higher employee numbers. In more modern industrial buildings, the office component has reduced significantly and buildings are made to accommodate increased machinery and technology use as opposed to labour.

Figure 9: New industrial completions by province (2005-2015)

Limpopo

1%

North West

1%

Gauteng

38%

Free State Northern Cape

1%

Mpumulanga

4%

KwaZulu-Natal

20%

1%

Eastern Cape

7%

Western Cape

27%

For the new industrial occupier, four key factors are of major importance: Safety & security Access & large yard spaces

Four key factors

Location

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Larger maxi units

Access and large yard spaces This accommodates larger trucks and cargo vehicles which are moving various goods. Turning space in the yard is of high importance and easy access into a storage or warehouse buildings is key. Location The importance of location is driven by ease of access to major transport routes on the one hand and the advantage of advertising on the other. This has contributed to the popularity of buildings in Plumbago and Jet Park in Kempton Park, Meadowdale in Modderfontein, and Waterfall Estate in Midrand which offer highway frontage to occupiers and an opportunity for outdoor marketing of different brands or retailers.

Safety and security Developers have seen the growing interest in accommodation in business parks which offer controlled access in a country that is battling with crime. Larger maxi units Occupiers are looking for big boxes, particularly for distribution and logistics use. Businesses are seeking ways of creating efficiencies by doing more with less. High warehousing buildings make use of technology, stacking up large quantities of goods with minimal labour.

Challenges in the industrial real estate market Infrastructure backlogs The growth of warehousing and logistics activity has put increased demand on the limited infrastructure in South Africa. The most compelling problem is the growing backlogs at the Durban port which have created time delays, and increased costs for both exporters and importers. Although users have continued to experience frustration at the port, Gary Young, Real Estate Manager for Transnet National Ports Authority, indicates that there are steps being taken to reduce the backlogs. Transnet is upgrading some of the roads and has created some truck staging areas to reduce traffic. There is also a project underway to upgrade six berths in the Maydon Wharf Precinct of the port and there are plans to develop new berths for larger vessels. In addition, there are also plans to reduce the time vessels spend at the port by speeding up the process of loading and offloading of goods. With regard to the transportation of goods, an inefficient rail network has contributed to the overuse of road infrastructure in the country. Transnet has initiated a drive to increase the utilisation of rail at the port, with plans in place to lengthen the cargo track. Airports Company South Africa (ACSA) is also looking at improving cargo terminals

at O. R. Tambo International Airport, Cape Town International Airport and Lanseria Airport. While the plans are encouraging, the major drawback is the delay in implementation of these plans. Young mentions that some of these plans are set to commence in 2016, “provided that Transnet is able to secure the funding”. Aside from Transnet’s plans, Gauteng is still to see clear progress in the upgrading of City Deep as a key inland sub-port from Durban to the northern provinces of the country, while there is little pointing to progress in ACSA’s plans. In the meantime, the market views these transport inefficiencies as an obstacle to stronger trade activity in South Africa. Labour Labour dynamics in South Africa are often reduced to the strength of unions and the rising costs of employing labour. Nevertheless, the importance of labour in the industrial sector is mostly focused on the manufacturing side more than the logistics and warehousing subsector. Although labour issues are a contributory factor to the challenges in the mining sector, power supply and low demand from our major exporting partners have been overriding

Add pic

factors. Overall, with the declining activity in the manufacturing sector, employment in the sector has also been on the decline which is seen as a greater sign of flexibility in the market than what is often argued in the private sector. The major challenge with the decline in employment in the manufacturing and related sectors is the declining purchasing power of lower income households. What is evident in the South African market is that gross earnings have continued to increase despite the decline or stagnation in employment. This is an indication that income is becoming concentrated in the middle to high income earning groups while the decline in unskilled employment exacerbates conditions for low income households. This has the potential of fuelling political unrest as the inequality gap widens. In summary, there is a compelling reason to preserve manufacturing activity in the country for the creation of unskilled to semiskilled jobs. Manufacturing is able to absorb more numbers than most of the other sectors in the economy which are showing growth. It is also key for the country to be able to maintain a position of food security which is increasingly becoming at risk in South Africa as a result of cheap imports.

Figure 10: Inflation and exchange rate

%

10.0

R14

8.0

R12

6.0

R10

4.0

R8

2.0

R6

0.0

R4

-2.0

R2

-4.0

2003 2004 2005 2006 2007 2008 2009 2010

CPI Inflation

2011 2012 2013 2014 2015

R/US%

R0

Rand/US$

Exchange rate and the changing consumer profile The industrial sector is relying on the strength of the South African consumer’s balance sheet and any notable changes in this regard are a concern for the ongoing strength of the warehousing and logistics sector, especially because imports are playing such a significant role in local consumption behaviour. Inflation is a big concern to consumers of late, and any further movement in the currency is likely to see consumers adjusting their expenditure patterns accordingly, reducing luxury goods and seeking out cheaper alternatives in essential goods. While the Consumer Price Index (CPI) inflation rate breached the 6.0%

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mark in January, the local currency reached levels above R16.00 to the US Dollar in early 2016, forewarning of further inflation increases. In response, the Reserve Bank has continued to increase interest rates, further eroding disposable income. If these changes are temporary, then import volumes may not be dramatically affected, resulting in no significant impact on the demand for industrial accommodation. Occupiers are already operating under tighter trade models, shortening the merchandise cycle and adjusting to market demand with justin-time methods of stocking as opposed to keeping large sums of inventory.

However, if this trend is maintained for a notable period, in time it may result in a behavioural change for South African consumers, which may push tenants to downsize. Will market conditions sustain the growth in imports given recent changes? The considerable deterioration of the Rand in late December 2015 adds an interesting dynamic to the high import model of South Africa. In January 2016 alone, South Africa saw the trade deficit decline by 23.0% y/y with a decrease in imports contributing to the closure in the gap. Economists are anticipating that the Rand will further deteriorate over 2016.

Adjusting for international occupiers With activity largely being driven by international occupiers, the local market is beginning to adjust to international norms in the industrial sector, contributing to some challenges in the market. Industrial leases are shorter to allow businesses to adjust their needs according to market conditions, which in turn create uncertainty for the landlord.

Paul Stone, CEO Africa and MD South Africa, DHL Supply Chain, highlights this as one of the major drawbacks in the local industrial property market. In the European market, companies like DHL are able to lease readily available facilities over a short term period, and renew or terminate on expiry of the lease as required, which they cannot do in South Africa.

Another key difference is the attitude towards escalations in the global market in comparison to the local market. Whereas South African businesses are accustomed to a standard annual escalation agreed to on the signing of the lease, international companies require a flexible rate, possibly based on inflation and annual review. These have balance sheet implications for local investors as it affects the stability of income and could contribute to declining margins as the costs of maintaining buildings increases.

Non-speculative developments are catering to retailers that have centralised their supply chain, and have opted to operate out of their own distribution centres. However, this is leaving a portion of the industrial market under-serviced, with logistics companies operating a totally different business model and requiring even more flexibility. It is worth noting that Capital Properties (which has been purchased by Fortress) is a notable exception to the non-speculative development model, as they have actively pursued a strategy to secure strategic land suitable for big box distribution on a national basis, and have aggressively developed big boxes on a speculative basis. The risk associated with developments of this nature will require local investors to rethink their traditional business models to achieve profitability.

Lastly, in contrast to permanent occupiers such as large retail chains, pure logistics companies require accommodation that will be able to respond immediately to changes in demand. This calls for the availability of speculative developments, an obvious risk to investors.

The risk associated with developments of this nature will require local investors to rethink their traditional business models to achieve profitability. COPYRIGHT © JONES LANG LASALLE IP, INC. 2016. All Rights Reserved.

Outlook and concluding remarks

While there are challenges in the industry, it is clear that South Africa is a part of the global village. Local consumption cannot be exclusively satisfied by locally produced goods and the interest of international retailers and brands in the market highlights the potential in this market. Be that as it may, over-reliance on imported goods, especially on essential goods, places the economy in a vulnerable position to international shocks, while making the economy increasingly sensitive to exchange rate fluctuations. This also limits the country’s ability to create employment opportunities. To this end, there is a case for reviving the local manufacturing sector and strengthening the country’s export potential which will also reduce the trade deficit. Prevailing economic conditions have highlighted the importance of fiscal policy in the economy and government’s implementation of a development policy has the potential to foster a new wave of growth in local industry. There has been extensive talk of the Industrial Development Zones across the country. Infrastructure spend is broadly viewed as a key tool to reignite the construction and manufacturing sectors in South Africa which could broaden and diversify the makeup of industrial accommodation in the economy. However, the country is seeing slow progress with regard to infrastructure expenditure which could discourage potential investors and entrepreneurs.

In 2015 the economy also saw the launch of the Black Industrialist Programme which sets out to create new players in the local manufacturing sector. The success of the policy could see the industrial nodes being rejuvenated. In the meantime, developments in the industrial sector are likely to continue being dominated by large light industrial warehouses, which have gradually come onto the market with detailed planning and foresight. The majority of developments have been non-speculative in nature, hence there is no real threat of a sharp oversupply in the market. Rather, older stock that has become redundant may be in line to be redeveloped for alternative uses. The expansion of light industrial accommodation warns of the increased pressure on transport infrastructure in the country, which is already showing signs of deterioration. Infrastructure upgrades are key for improving efficiencies in the local trade sector and the reinvestment and upgrade of ports, rail systems and roads is crucial for enhancing the growth outlook of the country.

In 2015 the economy also saw the launch of the Black Industrialist Programme which sets out to create new players in the local manufacturing sector.

JLL offices: Johannesburg Office 303, 3rd Floor, The Firs Cnr Biermann & Cradock Ave Rosebank, South Africa, 2196 Tel +27 11 507 2200 Zandile Makhoba Head: Research, South Africa Johannesburg Tel +27 11 507 2200 [email protected]

Craig Hean Managing Director: JLL Sub-Saharan Africa Johannesburg Tel +27 82 444 9598 [email protected]

Mark Truscott Industrial Leasing Lease Advisory, South Africa Johannesburg Tel +27 82 940 6856 [email protected]

Tatiana Jaspan Head: Marketing and PR, South Africa Johannesburg Tel +27 11 507 2200 [email protected]

Henry Playne Head: Capital Markets, South Africa Johannesburg Tel +27 72 763 4090 [email protected]

Simon Wade Head: Corporate Solutions, South Africa Johannesburg Tel +27 73 535 3787 [email protected]

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COPYRIGHT © JONES LANG LASALLE IP, INC. 2016. This report has been prepared solely for information purposes and does not necessarily purport to be a complete analysis of the topics discussed, which are inherently unpredictable. It has been based on sources we believe to be reliable, but we have not independently verified those sources and we do not guarantee that the information in the report is accurate or complete. Any views expressed in the report reflect our judgment at this date and are subject to change without notice. Statements that are forward-looking involve known and unknown risks and uncertainties that may cause future realities to be materially different from those implied by such forward-looking statements. Advice we give to clients in particular situations may differ from the views expressed in this report. No investment or other business decisions should be made based solely on the views expressed in this report.