Lately, it seems like not a month goes by without the announcement of some major new logistics transaction in Europe. Once one of the sleepier segments of the real estate market, logistics is now clearly on fire. If you read through the public statements associated with these transactions, you find two consistent investment themes: the impact of the growth in e-commerce and the attraction of a high-yielding sector that may be due for a re-rating. Let’s take a look at both of these rationales.
As an aside, Peakside approaches this field with a good deal of experience. Back in 2006 and 2007 during our former incarnation as the real estate arm of Merrill Lynch in Europe, we were very active in development, which we liked due to its ‘short-cycle’ nature. Indeed, sheds could be built in five to six months, which made it easy to build into visible demand and with predictable margins.
E-commerce certainly is revolutionizing the retail scene, but its impact on the logistics sector is far from unambiguously positive. One of the biggest current users of logistics space is the conventional retail sector. To the extent that e-commerce is stealing sales from the bricks-and-mortar guys, then the latter clearly will need less space going forward. Given that we are in a very low growth environment in Europe and likely will remain this way for some time, ‘cannibalization’ rather than market expansion has to be the reasonable assumption.
The growth of e-commerce therefore will only increase aggregate demand if it requires more logistics space per unit of sales than conventional retail. Although this seems plausible, I have never seen any definitive studies to prove it. In any event, given the extraordinary competence I experience with my daily Amazon shopping, if e-commerce is more inefficient in the use of logistics space, I doubt that the difference is large.
Still, that is just a discussion of aggregate demand. The bigger problem, it seems to me, is that aggregate demand may not be very relevant. With its emphasis on “the last mile” and the race to respond to the consumer’s desire for instant gratification, the type of facilities required by e-commerce is likely to be very different from the current ones. This means that many of the existing assets might find demand from their conventional tenants falling without any compensating increase from e-tailers.
Moreover, only looking at demand is a bit like trying to cut cloth with only one blade of a scissor. The other blade is supply, which returns us to my earlier comments on the virtues of logistics development. The major players in the logistics market hold sizable land banks, usually contiguous to existing buildings, fully serviced and ready to go. When tenant demand pushes rent levels high enough to create capital values above replacement cost, these land banks produce new sheds faster than mushrooms emerging after a spring rain. This explosion of supply limits rental increases and keeps capital values close to replacement costs. So, even if opportunistic buyers get the demand side of their investment thesis right, if they haven’t bought at a discount to replacement cost, it is hard to see how they are going to generate significant capital gain.
The second appeal of the sector is its relatively high yield. In addition to providing an attractive cash return, this is thought to create a decent chance for capital gain through cap rate compression. The latest figures from CBRE show an average industrial yield of 7.92 percent, more than 210 basis points higher than office and almost 270 basis points higher than retail. You can understand the attraction of these incremental returns for an investor charged with meeting pension liabilities or enhancing the wealth of its sovereign fund.
These numbers, however, should be viewed with caution. One of the great weaknesses of yield as a measure of real estate value is its total failure to capture the costs of depreciation and obsolescence – factors that have been greatly accelerated for logistics space by the advent of e-commerce. E-tailers and retailers still are jockeying for position, trying to find the optimal combination of delivery options. The currently optimal combination is certain to change in the future as new technologies (such as 3D printing) emerge and consumer preferences change. This fact increases the obsolescence risk of buildings and also means that the operational risk of logistics investment has increased sharply, since it will be necessary to understand and follow a fast-changing retail scene in order to invest successfully. What is needed is compensation in the form of a higher yield, which suggests that the sector may not be as cheap as some believe.
Finally, even if a re-rating of the sector takes place, we still have to deal with the supply issue. A reduction of logistics yields would have the same effect on development economics as an increase in rents; the supply response would be the same. This means that, over time, lower yields would translate into lower rents for tenants and not higher capital values for owners.
Don’t get me wrong. Those that are fleet of foot and have the right assets, land and expertise for changing patterns of demand will do well. It is just that my natural inclination is to ‘lean against the wind’ and to raise questions about any investment trend that suddenly has a large number of followers and display overdone enthusiasm and under-done thought.