This article is sponsored by Cromwell Property Group
European logistics real estate has been one of the few sectors in the region to survive the pandemic not only unscathed, but with its appeal to investors enhanced. However, the burgeoning popularity of the asset class has increased competition and pricing, creating a high barrier for market entrants keen to gain a foothold.
Michael Bohde, Lorenzo Caroleo, and Andrew Stacey, respectively the heads of Germany, Italy and France at listed Australian real estate investor and investment manager Cromwell Property Group, discuss how their markets have fared in 2020 and argue that managers need expert local teams to facilitate capital providers’ access to sought-after opportunities in the region’s logistics market.
How has covid-19 impacted logistics in your markets?
Michael Bohde: Over the year prior to the outbreak, investment volume, rents and take-up, the latter especially in Tier 2 locations, were all increasing in Germany, while vacancy was reducing. Since then, demand in certain sectors like automotive has fallen, but others such as e-commerce and food logistics have underlined their continued systemic relevance and have shown strong take-up.
Overall vacancy did not change dramatically, remaining very low. Covid has accelerated the trend toward e-commerce and has led to an increased demand from retailers for logistics space. The number of insolvencies is expected to increase once government support packages come to an end. However, logistics will continue to benefit from the shift toward online trade.
On the capital markets side, covid-19 has also been an accelerator. Demand for logistics assets has increased, not least because institutional players have shifted part of their real estate allocation to logistics from office and retail. That is especially true for German equity.
As a result, Germany saw a 14 percent year-on-year increase in logistics transaction volumes to €5.6 billion at the end of September 2020. Of that, almost €4 billion was in single-asset transactions, which demonstrates that the asset class is attracting interest from a wider range of investors. Also, logistics’ share of overall investment volume has increased on a year-on-year basis.
Lorenzo Caroleo: In Italy, investment volume and take-up have been skyrocketing and have only been constrained by the lack of product.
Investment volume for logistics amounted to €1.4 billion last year, representing 16 percent of the nation’s total investment volume. It is the only sector that has experienced growth, whereas office, retail and hotel have all plummeted.
The main difference between Italy and northern Europe is that e-commerce penetration in Italy has always been among the lowest across the continent, at about 5 percent of total purchases. However, that is within a context where Italians are among the biggest shoppers. Because online penetration is forecast to increase, that will quickly have a positive impact on warehouse take-up.
Andrew Stacey: Occupier take-up in France was down in 2020 by 31 percent year-on-year, although it was only 13 percent below the 10-year average of around 3 million square meters. That is unsurprising given the virus-related disruption we have seen.
Pure e-commerce players have only accounted for 15 percent of transactions, but most third-party logistics facilities have some space dedicated to online sales, so the impact of e-commerce is understated in those calculations, and it will continue to transform the sector over the coming years. Meanwhile, investors all want a piece of the logistics pie, and there is not enough prime investment product to go around.
The short-term uncertainty surrounding potential take-up means many developers have put speculative building on hold, and banks are cautious about providing development finance. Getting new product out of the ground is an extremely fraught business in France in any case, so modern buildings will be difficult to supply, which will keep prices high.
How can investors unearth opportunities in such a hot market?
AS: Pricing is extremely sharp for all the different grades of product, which is why you need local expertise. Over the past few years, we have seen new money coming in that is desperate to invest, sometimes making unrealistic assumptions on rental growth, lease renewals and capex. If investors have access to on-the-ground knowledge it helps them to understand the occupier, the length of their contract, and whether they are likely to move or not, so they can build that into their pricing and avoid making expensive mistakes.
LC: Logistics real estate in Italy is cheaper than Germany, France and the UK. Investors see the opportunity for further compression of prime yields.
A lot of the stock in Italy is old, so we see many investors adopting development strategies to create the new buildings that are much sought-after by end users. The challenge in forward funding and development is that seller expectations are very high. That means there is little or no risk premium for buying a development instead of a stabilized product to compensate for the additional risk.
However, we are strong supporters of forward funding strategies when we do not take the planning risk: as most new assets are either build-to-suit or let during construction, risk for the buyer is mitigated. Italy is a long, thin country, so even in secondary cities there is scope for logistics parks to satisfy local demand.
Northern Italy is the wealthiest region of the country and prime logistics hotspot, but nevertheless we see an increasing volume of capital seeking opportunities further south, including from institutions like insurance companies, which you would previously never have thought would invest there.
With all the huge interest in the sector, the danger is that investors might overpay or take too much risk: our strategy is to provide protection to investors by taking more capex risk in liquid locations in the wealthiest areas of northern Italy, while we take location risk or short lease risk in secondary locations which have the fundamentals to grow.
“Pricing is extremely sharp for all the different grades of product, which is why you need local expertise”
MB: Structured sales processes are becoming more and more competitive. An additional way to unlock opportunities is to approach private and institutional owners directly. For instance, among the German corporate Mittelstand of small-to-medium sized enterprises there are many hidden champions with great credit quality and business models.
It is likely that the number of sale and leaseback transactions will increase because those companies can make better use of their capital than having it locked in real estate. To identify those opportunities, you need people on the ground with local market knowledge.
What are the implications of the evolving requirements of modern logistics occupiers for investors in the sector?
AS: Historically investors have found the leasing structure in the UK most attractive, with 10- to 15-year leases. Continental Europe has offered more flexibility to occupiers, and in France the tenant usually has the opportunity to break their lease every three years.
There is always pressure from occupiers for more flexible lease terms, particularly from third-party logistics operators which would prefer to sign leases which match the length of their contracts, which are frequently two years or less. However, to fund a pre-let at least six years’ term certain is required.
E-commerce players want to put a lot of equipment into their building, so they have to take a longer lease to make the capital expenditure worthwhile. Therefore, as e-commerce becomes a higher percentage of the market that could provide impetus for longer leases in mainland Europe, which would be good news for investors.
Meanwhile, as automation becomes more common over the coming decade, labor will cease to be such a key driver for location selection. As long as they have the power supply, businesses like Amazon will be able to locate in a field in the middle of nowhere because picking and trucking will be automated.
LC: When the occupier is a third-party logistics operator, investors need to consider the building’s location and how easy it will be to replace the tenant if they fail or terminate the lease. As more institutional players enter the Italian market, they are demanding longer, institutional grade leases.
A lot of leases signed by private landlords and developers at the moment are not up to that standard. That has to change if they want to attract institutional buyers.
Assessing the impact of technology is not straightforward. E-commerce businesses all utilize different systems, for which their buildings have to be suitable. If they leave, the owner has to consider the effect on future value and security of the income stream.
There is no prevalent technology yet, so flexibility has a value. We have first-hand experience of lenders preferring a classic third-party logistics shed over modern last-mile space because of that.
What will be the effect of rising expectations for ESG standards?
AS: Where you are able to show a tenant how much they can save by taking a more efficient building, then it is a lot easier for them to sign a lease at a higher rent. Building performance will be very important in the logistics market going forward. That will render a lot of buildings obsolete and give rise to opportunities for redevelopment and value-add investment because there is such a shortage of development land in good locations across the whole of Europe.
LC: For the oldest stock in Italy, it is challenging to implement ESG requirements. If you add the capex required to improve the specification, the total final cost will probably be above the replacement cost.
The numbers have to stack up. But at the moment seller expectations are very high. However, for modern, low-emission assets there is plenty of transactional evidence that they are highly liquid and command prime yields.
Local knowledge helps crack DHL conundrum
Italian warehouse portfolio purchase took a year to assemble
In October, Cromwell completed the acquisition of a portfolio of northern Italian warehouses, all let to third-party logistics operator DHL for 10 years or more, in a €51.0 million deal. Cromwell is considering using the seven assets to seed a European Logistics Fund which would focus on core plus logistics assets throughout Benelux, France, Germany and Italy, with a target total gross asset value of €400 million to €500 million.
Korean investor IGIS Asset Management provided equity capital, with Cromwell co-investing from its own balance sheet.
Caroleo says: “In this market local knowledge and expertise is needed to source attractive opportunities and unlock product that is in the hands of private families. DHL put together the package but we negotiated with seven different private owners over the course of a year to assemble the portfolio and transform it into an institutional grade product. How could any investor without a local expert partner be able to navigate the peculiarities of Italian red tape, understand the local environment, put together the portfolio and complete the deal?
“At Cromwell we position ourselves as the local partner for Asian and other international capital partners and whether it’s opportunities in Italy or with Andy in France or Michael in Germany or any of our other key European markets this transaction is a great example of what we can do.”