This article is sponsored by Logistics Capital Partners. It appeared in the Investing in Logistics and Distribution supplement with the February 2019 issue of PERE magazine.
Increased automation and the need for economies of scale are propelling demand for bigger, higher distribution centers, of which few currently exist. Meanwhile, outbidding rivals in a fiercely competitive market for existing assets can be an expensive approach. In that context, James Markby and Kristof Verstraeten, joint managing directors at developer and asset manager Logistics Capital Partners, make the case for development, and analyze southern Europe’s burgeoning institutional warehouse investment market.
PERE: What’s the key to building an institutional logistics portfolio in today’s market?
Kristof Verstraeten: Everything points to development. Aggregating quality assets in this sector is increasingly difficult because there’s a lot of capital allocated to logistics chasing the same product. At the same time, all the trends in the sector – e-commerce, consolidation at increased scale, mezzanines and multi-level buildings, automation and robotics – have triggered much more development and reconfiguration of existing buildings. A lot of the future demand from occupiers will be a poor match for the buildings currently available. That has two effects: first, old buildings in key locations close to city centers will be upgraded. That is the rationale for a value-add strategy we’re pursuing in Italy with The Carlyle Group, acquiring older buildings and doing asset management with an upgrade component to it. Second, a substantial part of demand in each market doesn’t fit any existing building. That is especially true for extra-large logistics buildings of 50,000 square meters and more. There’s virtually no availability of existing buildings of that size, so that demand is all pushed toward new development. So is demand from occupiers keen to use more robotics and automation, because that cannot usually be easily accommodated in existing buildings. Meanwhile, labor shortages in a number of key European locations are forcing occupiers toward rethinking their networks and using more automation.
James Markby: Automation leads inevitably to intensification of use. It requires higher cubic capacity. Often occupiers are still designing the buildings and automated systems while concurrently running their real estate search, and it is only at the last minute that all those things come together and the developer gets informed about it.
PERE: Does that favor build-to-suit development?
KV: To some extent yes, but if you have enough contact with occupiers you can figure out the features and elements that work for everyone and design a flexible shell building for speculative construction, provided you’re prepared to run a customization project for your specific tenant afterward.
JM: Today, many operators are asking for build-to-suit designs that might have been considered non-standard a few years ago. You still need to design buildings that allow enough flexibility to be re-used at the end of the lease, but because a growing section of the market wants higher buildings with more mezzanines and bigger yards, and higher energy and amenity specifications, those features are becoming less bespoke.
KV: Not only is there is very substantial demand for buildings that need to be developed, but if you approach the market through development you are more likely to end up with buildings that are future-proof because they already have the modern features that conform to the next-generation specification rather than a current or older one. Those are two of the main reasons for taking a development approach to investing in this market.
PERE: What are the challenges involved in securing capital backing for a development-based strategy?
JM: There’s clearly lots of equity capital of every type available for logistics at the moment. However, following where occupiers want to go and developing the buildings they need requires institutional capital at scale that’s comfortable with a moving set of targets and risks. Buildings are designed and evolve, locations change and factors like planning restrictions come into play, so there’s a whole set of timing and practical complexities. You have long lead times then very compressed timescales to execute all the contracts. We ran a process to find that kind of capital and in November we formed a partnership with Invesco. They provide capital into LCP’s balance sheet as a corporate finance facility that gives us a broad degree of discretion over how we secure and build out the development pipeline. If we couple that with existing bank and lending relationships, over the medium term we can build out over €1 billion of end value. This fits nicely with another, complementary, strategic partnership with the listed Tritax Eurobox fund. We are the exclusive asset manager to Eurobox in all countries (except Germany, where they also work with Dietz) and it is the aim that our development pipeline is offered to Eurobox for acquisition. The Tritax Eurobox management team have set themselves apart from other general logistic funds and managers from the outset by anticipating the importance of these evolving market dynamics and teaming up with a specialist developer such as ourselves. This allows them to follow customers across Europe, to provide immediate access to the latest generation of buildings coming from our development pipe in multiple markets, and then future enhance performance and operational efficiencies from us managing those buildings and key occupational relationships for the longer term.
KV: Generally speaking, logistics is popular with banks and alternative lenders and funders, but we’re seeing a bit of a differentiation between the institutions and companies that are willing to lend for development and understand the evolution of buildings and technology, and those that don’t. A very large building can either be perceived as a liability – the old-fashioned view would be ‘If it becomes vacant how will I re-let this?’ – or it can be seen as a positive because the tenant is less likely to move out and if they do you’ll probably own the only large building in a market where the demand for large buildings is strong. Some lenders understand the opportunity and are very actively pursuing it; others are sitting on the fence and haven’t made the jump yet.
JM: Senior lenders, in particular, are also becoming divided between those that can follow in the development process and those that cannot, and which are only looking for buildings of the type designed five years ago. It may be that the latter group will find it harder to allocate their loan books because they’re missing a major part of the future growth of the market.
PERE: LCP has been very active in southern Europe. What is the investment opportunity there?
KV: The economic cycles of northern and southern Europe are running at a slight offset with southern Europe slightly behind, so if there’s a downturn then economies there will go into recession later, and because they are more state-subsidized than those in the north they tend to do so at a slower pace. Growth in the south is also less closely related to manufacturing and trade, and more to general consumer spending, consumption and demographics.
JM: We think there is relative value to be captured there, and a competitive advantage if you can operate effectively in those markets compared with others that are already saturated with other strong developers.
KV: Another difference today still between northern and southern Europe is the depth of the market and the number of institutionally accepted locations. In Germany, the big brokers report on 17-20 logistics hotspots, located around every big city. That has evolved, because 20 years ago they would only have reported on Hamburg, Munich and Frankfurt. By contrast, if you look at where institutional investors focus in Italy, it is limited to Milan and maybe Rome, whereas in fact there are probably 10 sizeable logistics markets linked to urban centers. In France, investors traditionally look at Lille, Paris and Lyon as the three key markets, but there are a lot of other interesting markets near big population centers. The same applies in Spain; the Malaga area has a population of three to five million people depending on how wide you draw your radius. It’s a substantial logistics market, but it would not traditionally be on the radar of many investors. There’s an opportunity in southern Europe similar to the one that existed in Germany more than five years ago when institutional investors began to spread their wings a bit. It’s a less crowded market with the potential for growth and improvement because it is earlier in the cycle. Those factors will contribute to longer-term returns.