This article is sponsored by Logistics Capital Partners
The past year will have created winners and losers for investors in European logistics for the first time in a decade, with sharp rises in interest rates pushing up yields and damaging performance in some areas. However, headline-grabbing reports of the sector’s demise are exaggerated, say James Markby and Kristof Verstraeten, managing directors at Logistics Capital Partners.
Tenant demand for logistics property remains very strong and the right business model can ensure success, even when investment returns are affected by rising yields. A focus on adding value through site acquisition, planning, tenant relationships and ESG measures is the recipe for success in any sort of market, they argue.
Logistics real estate returns have been damaged by rising interest rates and thus yields, what is the state of the market today?
James Markby: There has been a fundamental issue in 2022: the most aggressive interest rate hikes in a generation. This is a global phenomenon and affects all asset classes, including real estate and all its sectors.
All asset classes would have had a tough year from an asset management perspective. Logistics, has particularly been in the headlines as it is coming off a boom market with sharp yields, so the relative shift could feel dramatic in the short term. But, unlike a boom cycle where “a rising tide lifts all boats,” not all performance in a downturn will be the same across the sector.
2023 will become the year for differentiation, with a return to good long-term fundamentals of assets and investment structures.
The poor performance headlines also ignore the sector’s strong underlying fundamentals, and in particular that some groups and structures are better positioned than others to withstand a period of weaker capital markets, and now have the potential to quickly capture the new opportunities.
Agents are reporting record take up across Europe and record low availability, which is not going to change in the short term.
There is still very low supply and it is increasingly limited due to planning restrictions and politics. Tenant demand remains strong because of the ongoing de-risking of supply chains, which involves nearshoring and the need to hold more inventory.
Kristof Verstraeten: It is not just that warehouses are fully occupied on a tenancy basis, they are full! Almost everywhere they are full all the way up to the ceiling. We hear of space pressure for logistics occupiers across the market.
There is also a lot of press coverage of a slowdown in e-commerce after the pandemic, but this is simply a return of growth to the long-term prognosis. E-commerce was growing before the pandemic and then during covid there was an acceleration, with probably two or three years of growth in just one year. That is slowing down now but all that has really happened is that we are moving back towards the original evolution curve of online penetration.
How important is ESG when it comes to adding value to logistics assets?
JM: Logistics buildings which aren’t future proofed and ESG compliant, priced at attractive levels, which would allow refurbishment and installation of more efficient systems, I think is a is a definite opportunity to add value. The redevelopment of brownfield sites is going to be an important part of the industry in the coming cycle.
You need to ensure your buildings are attractive in a part of the cycle when investors are going to be more selective. This should drive people towards higher quality assets which can be part of further steps to net zero. We are already seeing this; we have seen a host of investors and developers who for the first time are announcing that their next project is going to be net zero or carbon neutral.
KV: What we are already seeing in conversations with investors and tenants is that there is going to be a clear bifurcation in the market, both on the capital and the tenant side, between assets which are energy efficient – and therefore cost efficient – and those which are not. Tenants are more interested in buildings with ESG performance and ultimately will be willing to pay a higher rent for them.
JM: We offered an Italian warehouse for sale and offered investors the option of paying extra for the asset to be embodied-carbon neutral. As a consequence, in the final stage of offers, we got improved pricing and subsequently set a market record for logistics in Italy.
Is there still investor appetite for logistics bearing in mind the upheaval in investment markets recently?
JM: The market is still up in the air with regard to pricing and there is a gap between live prices and historic portfolio valuations, but once they catch up over the next couple of quarters we will have a clearer picture. There is a lot of new capital which was allocated to logistics but was priced out in the past couple of years.
This capital is still out there, many investors remain under allocated to the sector and values which are 20-30 percent off their peak will look attractive. Combined with strong rental growth that means investors can hit the right returns and perhaps operate in a less competitive environment.
KV: Certainly, if you bought standing assets in the first quarter of 2022, at the top of the market, and revalue this today, your performance would be terrible, but that applies to relatively few investors. Others see the long-term attractions of the sector. Rental growth is ultimately the key investment argument for the sector today; that is what investors want from real estate.
JM: For discerning operators embedded in their markets, there are always opportunities to create value at all stages of the cycle. We bought a large site in the West Midlands, UK after covid but before the war in Ukraine. You would expect pricing to be toppy, but we bought at an excellent price because there was a discount due to the complexity of delivering a scheme there.
“We believe that our developer/trader model is a much more defensive business model than people realize. One of the big reasons for that is you are trading and crytallizing your profit all the way through the cycle”
A relatively low land value per acre and large contingency assumptions have insulated us from subsequent movements in the market. We have plans for a rail freight terminal and interest from more tenants than the initial stages can accommodate, so we still anticipate a great success, even though it was acquired late in the cycle.
So, what operating models are most effective in the current logistics real estate market?
JM: There is an important differentiation between simply aggregating assets in the anticipation of cap rate movement and adding real value. The former means you can be unlucky with market timing. I think more discernment will now come into the market, because of some of the pain that has been felt. People are going to look at the fundamentals a bit more closely than they have been doing. And we expect investors will do more diligence on their operating partners as well.
We believe that our developer/trader model is a much more defensive business model than people realize. One of the big reasons for that is you are trading and crystallizing and taking your profit all the way through the cycle. You are creating value that isn’t dependent on the capital market.
We are creating buildings, structuring leases, converting brownfield sites and refurbishing assets to improve ESG credentials. That is all nitty gritty value creation that isn’t dependent on the capital markets.
“Rental growth is ultimately the key investment argument for the logistics real estate sector today”
KV: A well-executed developer-trader business model is inherently built on adding value to the real estate, so from our point of view it doesn’t really matter that much where the precise yield is as long as there is a spread between where we go into a project and the total cost, and the value we create and how we exit it. Provided that you add value along the way, it is a robust business model throughout the cycle.
In an uncertain market, it is important to be defensive. How can that be achieved in logistics?
JM: You must be close to your occupiers, which is where we spend a lot of time, delivering the logistics space they need. This is also an important part of overall investment market liquidity.
Some occupiers are looking for turnkey developments or to buy out their lease or acquire a property. We have had good liquidity moments during the last year; for example, a turnkey deal to Costco in Madrid, in May, when the rest of the market was paused.
We have just over 16 million square feet of development pipeline right now and 80 percent of that is de-risked due to pre-letting, turnkey deals and sales to occupiers, or off-balance sheet joint ventures. That is good insulation against changing capital markets.
Rising finance costs are an issue for a lot of real estate players, but if you are developing and adding value, it is not so important a factor, compared with those who are aggregating assets and looking for yield shift. We have operated with relatively low leverage in the past cycle and can continue to do so.
That is a consequence of the development process and where value is added along the way. Not being reliant on leverage as the key factor to boost returns is another defensive factor.
Is this a good time for logistics real estate businesses to be expanding?
JM: We are very excited about buying more land, while others are shying away. We want to use our balance sheet to really grow our book after the last couple of years.
It is also a moment to diversify our activity and data centers is an area of particular new focus. Capital markets have not been so much affected there by the interest rate hikes and it is difficult to create sites which work for hyperscale operators, so there is undersupply and a real need for more.