Prime logistics has been European real estate’s star performer for a decade, notching up an annualised return of 15% since 2013 according to CBRE. It has been a major beneficiary of structural changes in our shopping habits, supply chain adaptation and localisation trends. Vacancy currently sits at a record low of 3.1%, according to Savills, with rental growth and yield compression occurring as a result.

Logistics has not been immune from recent price corrections. CBRE estimate average prime yields moved out by 62 basis points to 4.8% in the 6 months to Q1 2023, but they still predict it will be the best performing real estate segment over the next five years. Given its prospects, investment is competitive. Stock is tightly held, and quality assets can be subject to aggressive bidding. But investors are missing an alternative path which can deliver logistics-style returns at better entry prices: light industrial.

What is light industrial?

Light industrial is a type of use, rather than a type of physical asset like “big box” logistics. It is space used for value-added activities like goods assembly, production and storage or research and development. It often includes a logistics component. Typically, light industrial has higher office content than logistics and consists of smaller assets below 15,000 sq. m (160,000 sq. ft) or multi-let tenancies of 250–2,500 sq. m (2,700–27,000 sq. ft). A wide variety of activities occur under one roof making it a more complex product.

In most European markets, the amount of light industrial stock far exceeds logistics stock. However, it is overlooked, because it is largely held by non-institutional owners and it is bespoke and broadly distributed within business parks or stand-alone sites. This is a mistake. Light industrial has powerful fundamental drivers which point to sustained future performance. It takes a hands-on, detailed approach to unlock its value but investors who do so are set for rich rewards.

Why is it attractive?

1. Occupier demand
Like logistics, demand for light industrial space is extremely strong as occupiers benefit from direct exposure to the same cyclical and structural trends. They tend to be small and medium-size enterprises (SMEs), a sector that comprises over 23 million businesses according to the European Commission. The sector grew 3% between 2018 and 2022, equivalent to 708,634 more businesses, creating ripe rental growth conditions.

Following COVID-19 and the Ukraine invasion, trends like reshoring and increased stock inventory have fuelled demand. As SMEs, their covenants are perceived as weaker than large corporate entities, but many trade strongly, which is verifiable through due diligence. The high number of businesses means that, in an active local market, there are multiple alternative occupiers to take space should vacancy arise.

2. Limited supply
There is a shortfall of light industrial space, although a lack of data transparency makes this hard to quantify on a market-wide basis. New development has been focused on logistics and the pipeline has fallen materially due to higher construction costs, interest rates, economic uncertainty, and labour shortages.

Because of intense urban land pressure, light industrial stock is being eroded through redevelopment for alternative uses which squeezes supply further. Much existing stock is dated and misaligned to occupier demand for modern, well-specified, sustainable floorspace. This creates opportunities for active investors to get their hands dirty improving assets and increasing rents.

3. Entry pricing
Unstandardised product, the need for stock selection granularity, small lot sizes, and an active management requirement deters many institutional investors who prefer to concentrate on simpler big box logistics. This means pricing is better. Historically the yield gap between prime logistics and light industrial in Europe is 75–100 basis points despite their similar performance drivers.

Yields have softened lately, making an excellent entry point given light industrial rental growth prospects which are commonly indexed to inflation. Rental growth over the last few years means the capital value of assets bought several years ago at lower rents and yields are comparable to those today despite higher yields.

4. Optionality
Light industrial is a use type, not a physical asset type, so the real estate itself can be used in a number of different ways by a range of occupier types. It is easy to align assets to local market demand or to pivot them to serve pure logistics uses without heavy capex or refurbishment. Because many light industrial assets are situated in urban areas, rising underlying land values offer future upside potential via densification of light industrial or logistics uses or conversion to other uses entirely.

How can investors capitalise?

Capitalising on the light industrial performance opportunity requires an intelligent strategy.

Firstly, investors must build their local market knowledge. They need a clear understanding of micro-level light industrial demand drivers and to identify, from the bottom-up, the best investment locations. Due to the lack of existing data, this involves granular analysis of local dynamics, supply and demand.

Secondly, they need robust stock selection criteria. It is important to acquire only the best stock, or stock in sought-after locations which can be improved to meet modern occupier need, meaning disciplined deal screening is paramount. Much existing, older stock is at substantial risk of obsolesce.

Thirdly, a proactive strategy is necessary to engage with occupiers and actively manage assets. This involves time and, for older stock, some capex, but doing so can add significant value.

Finally, it pays to cultivate local networks and build long-term relationships with the businesses, private investors and small funds who own or occupy most stock. Real estate has always been about relationships and that is particularly true for granular light industrial.

An attractive investment option

Strong fundamental drivers, recent price corrections, rising rents, growing occupier demand and limited institutional competition create a powerful investment thesis for light industrial. It takes work to dig out uncut diamonds and polish them up by understanding local markets, grappling with data opacity, and rolling up your sleeves on individual assets; however, the rewards are compelling. Investors can reap strong rental value growth, positive yield shift and better sustainability outcomes from improving assets. Who doesn’t like a diamond?