Logistics is now firmly established with real estate investors as a critical growth portion of their current and future property portfolios.
E-commerce is yet to mature and changing trade, technology and sustainability demands, which impact storage and fulfillment needs, means the role of logistics property has further room to move up the value chain.
As such, logistics real estate will be a key source of sustainable income as well as capital growth for investors. However, the changes in play will favour some logistics solutions more than others and not all real estate assets will be critical to the process. As a result, the need for selectivity in investment and detailed due diligence to underwrite growth potential is ever more critical, particularly given the elevated level of current pricing.
Keeping the logistics real estate supply side under control
Looking back, two decades define the European logistics property sector, each of which was characterized by different supply/demand dynamics that ended or began with the GFC.
Pre-GFC speculative construction resulted in high vacancy rates just when Europe’s economies fell into recession in 2009. By contrast, over the last 10 years, Europe’s core markets benefitted from principally built-to-suit (BTS) construction that kept supply levels in check and protected rental levels from any downward pressure.
Meanwhile, demand drivers including e-commerce fueled a growing need for new types of buildings and customization as online retailers and parcel companies searched for real estate solutions that could create efficiencies in their B2C supply chains.
Logistics sector attractiveness deepens the investment pool
Established as a viable alternative to the office and retail sectors, the European logistics sector has shown more resilience to cyclical downturns during the GFC and recovery in 2011-12 and more recently, during the current pandemic and economic slowdown.
The investor pool - attracted by real estate market dynamics, strong alignment with structural trends and sustainable income returns - has been targeting the sector since its recovery in 2012-13. This sustained interest has accelerated logistics to cycle away from other investment classes in recent years.
Lack of product has tightened the playing field for interested investors who are showing greater willingness to purchase logistics real estate at lower yields. As a result, increasingly aggressive pricing has compressed yields to currently 3.5-3.75% in core markets and sub 3% in London, the Midlands and Germany markets.
Bespoke buildings are at risk of long-term obsolescence
Pricing assumes a positive balance between supply and demand resulting in a defensive cashflow with growth potential.
However, investors have been less focused on fully understanding why tenants select specific locations and how it fits into their supply chain. For this reason, there is a growing concern that weight of capital looking to enter the sector is starting to overlook the basic components of real estate investment (i.e. location, location, location and a vanilla product which provides a safe reversion).
Historically, a successful developer was one that could interpret market demand and produce a building which appealed to as many occupiers as possible to drive competition.
Now occupiers are more selective and requirements are more specialised. In response developers changed their offer from standardised speculatively constructed buildings to BTS solutions, tailored to the logistics occupier. The benefit to the occupier is the ability to customise a facility. The risk for the developer and ultimate investor is a move away from the more flexible ‘vanilla’ position.
Micro-market knowledge of occupier trends, space requirements, supply chains and distribution channels is essential. This will ensure that investment yields properly reflect a potentially higher releasing risk and therefore functional obsolescence for highly customised bespoke buildings.
Commercial real estate fundamentals remain core
Considering the lack of developable land in most core European markets, resilience in this sector is principally associated with location just like any real estate investment.
Proximity to distribution corridors, freight transport connection points such as ports and airports and population centres is essential. The functionality of a warehouse is directly correlated to a location that offers easy access to one or more of these opportunities.
Enhancements to the longevity of a warehouse’s functionality centre around modern building specifications, as defined by each market, but that do not deter from its primary function: to serve as an “envelope” for logistics activities.
Despite typical longer lease terms between 10-15 years for build to suit (BTS) assets, pricing should normally reflect releasing risk. For example, the tenant pool is and will likely remain small for a bespoke fulfillment centre. A number of these XL warehouses were and are being built with higher than standard ceiling heights to accommodate the use of mezzanines, pick towers, automation or comprise highly developed rack supported structures. Contract rents reflect this additional floorspace but perhaps ignore the reversionary risk this ‘bespoking’ provides. Furthermore, bespoke buildings that rely on a m3 revenue capability, run a higher risk of not being able to realise the same revenue level on re-letting thereby making them potentially more vulnerable to functional obsolescence.