Nick Crothers

Movements in crude oil prices directly impact the bottom line of transport and storage companies. With strong rises in fuel prices reducing margins, what does this mean for the industrial property market?

The transport and storage industry has recorded a very large increase in gross industrial space take-up since 2000 - up from 285,000 sqm to 581,000 sqm in 2007, a 104% increase (with wholesale and retail trade also recording very strong take-up growth as a result of the growth in their distribution and warehouse requirements).

Research by Jones Lang LaSalle shows that changes in transport and storage sector profits have a strong relationship with the take-up of industrial space. When oil prices rise and profits fall, occupier demand decreases and there is a diminished propensity to expand space requirements.

Fuel costs are crimping the performance of transport companies
Rising diesel costs have increased transport operating costs. For example, since 2003, fuel costs as a proportion of transport operating costs have risen from a range of 11 13.4% in 2003 to 18–19.2% in 2008 depending on the truck type.

Companies unable to pass on the increased costs will have profit margins squeezed
Most transport companies charge their customers a fuel levy to cover the rise and fall in fuel prices during the term of a contract. However, a November 2007 Victorian Transport Association survey of its members found that 27% of respondents are not charging their customers a fuel levy. The Australian Trucking Association recently warned that transport companies that have not increased their freight rates this year to keep pace with the increased cost of fuel will need an increase of greater than 10% on average just to break even.

With strong rises in fuel prices reducing margins, what does this mean for the industrial property market?

Impacts on the industrial property sector in 2008
There has already been a drop in gross take-up so far in 2008 as businesses adopt a ‘wait-and-see’ approach to the market. In the context of the current supply cycle (record new industrial completions are expected in 2008), there may be a moderate increase in existing vacancy. We expect to see a weaker supply outlook in 2009 as a result.

Speculative development will be harder to justify due to additional demand risk and higher hurdle rates. With limited finance for speculative developments, supply in 2009 is expected to be significantly lower than in previous years.

Owing to a weaker demand environment, downward pressure on rents in precincts with a large development pipeline is likely, with the market expected to favour tenants over landlords. Competition for pre-commitments is likely to increase.

Not all markets will be equally affected. Transport and logistics companies focusing on reducing costs and travel times, and increasing operational efficiencies, will continue to seek out markets that offer them lower real estate costs as a proportion of their operating costs. This means that some operators may look to take short-term leases in secondary assets with lower rent.

In the longer term, the cost of fuel may contribute to an acceleration of the programme already underway to shift a greater proportion of freight via rail – in an effort to decrease truck movements on congested roads. A structural shift is already underway in the transport industry. In most states, government and industry have already agreed and set targets for rail.

For example, the New South Wales government and Sydney Ports have a shared objective of achieving a 40% rail mode share for containers that are transported into and out of Port Botany. In Melbourne, the government is pushing to increase the approximately 17% rail mode share to 30% by 2010. In Perth, a concerted effort has seen truck movements through Port Fremantle decreased by approximately 65,000 over six years and rail mode share increased from 2–14.5% in this period. The target is for a 30% share in 2012–2013.

As such, a priority for the industry is the identification and protection of intermodal terminal sites in major cities for development.

Real estate solutions for transport and logistics companies in a rising cost environment
As mentioned previously, margin squeeze may result in companies looking to reduce their overall real estate costs as a proportion of their operating costs. Several options can be used to accomplish this.

First, relocation to an alternative industrial precinct that has lower rent or land costs than their current location. On the eastern seaboard, this generally means moving to the western markets (south west in Brisbane, outer west in Sydney and north and west in Melbourne).

Second, relocating to an industrial precinct that increases operational efficiencies and brings about additional business cost savings – through shorter travel times, being closer to clients or suppliers, or by choosing premises that can help achieve efficiencies in the supply chain process. These options may not deliver a lower overall real estate cost, but the additional cost savings through business process improvement make an offset.

Third, businesses have been reducing the property held on their balance sheets so as to maximise their investment in their core operations. A tougher trading environment and tighter financing conditions will ensure that this continues to be an option for companies looking to free up equity.

Where to for oil prices?
The simplest explanation is that world oil prices are rising because demand is running ahead of supply. Disruptions to supply and speculation in oil futures by investment funds are not helping. But in the long run, oil reserves are running down and huge growth in oil demand from developing economies like China is almost certain to keep upward pressure on world oil prices in the years to come.

The strong Australian dollar has been shielding Australia from some of the pain – presenting upside risks if or when the dollar reverts. Consensus Economics forecasts that the Australian dollar will fall from the current spot rate of around USD 0.94 to below USD 0.86 by April 2009 and to around USD 0.81 in April 2010 (a 9% and 14% decrease, respectively).

Goldman Sachs recently asserted that oil prices could hit as high as USD 200 per barrel in a final ‘super-spike’ end game over the coming months. This will be followed by a sharp fall as businesses retrenched and demand recedes.

While currency and oil movements are extremely difficult to forecast, it seems likely that Australian companies will have to cope with high fuel costs for some time.

Conclusion
Until more recently, a strong domestic economy and consumer spending have been providing a safety net for the industrial sector. However, persistently high oil prices, along with tighter credit markets and slowing domestic demand, are constraining margins and crimping company profits.

Owing to the inability to pass on all costs through the supply chain, transport and logistics companies are experiencing margin squeeze. A move towards cost-saving measures is inevitable.

The willingness of industrial occupiers to pay more for real estate and the propensity to expand real estate operations during this time will be diminished. As such, the rental growth outlook in the industrial sector will be adversely impacted.

On a positive note, we observe that in the latest ABS survey of capital expenditure expectations for the transport and storage sector, the industry appears to have big plans for future capital investment in new buildings, structures, equipment, plant and machinery. We view this as a sign that the industry will continue to expand in strategic locations and invest in new facilities that will position them for future growth.

Nick Crothers is the national industrial analyst for the Jones Lang LaSalle Industrial Services team.

(MHD Supply Chain Solutions, Sep/Oct 2008)

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