It is inevitable that when a sector becomes increasingly popular, as logistics has become, there will be contrarians who offer an opposing view. However, Prologis believes the market is seeing a rare phenomenon in the cycle, where rental growth and yield compression are occurring simultaneously, caused by sustained occupier and investor demand, lack of supply and declining concessions.
Indeed, there is a robust case for investing in European logistics real estate: values today stand at a discount to both replacement cost and to what they were at the peak of the last cycle. In addition, at 7.3 percent, investment yields in Europe are hovering around historic averages, based on data from CBRE. Yields would need to fall more than 100 basis points to reach their low from the prior cycle, as they have in the US. In fact, yields already have begun to move lower, declining by approximately 20 basis points in the fourth quarter of 2013 alone.
Furthermore, the logistics occupational market has been remarkably resilient through the global financial crisis in contrast to most other property sub-sectors. Demand is underpinned by the ongoing reconfiguration of the supply chain and consolidation among logistics providers striving for greater levels of efficiency. According to leasing broker research, sector vacancy was 8.7 percent as of September 30, slightly better than peak levels of 9.3 percent in 2007 and down from trough levels of 12.5 percent seen in 2009. And compared to the US, which has more than four times the institutional Class A product, the European logistics property market is relatively underserved.
Indeed, e-commerce is a new positive for our asset class. Demand continues to grow and requires retailers to re-evaluate their distribution channels to support current demand, let alone expected growth. One major change in the supply chains of retailers is their shrinking store counts and footprints, which ultimately drives growth for modern logistics space. Retailers save on their occupancy costs while at the same time providing greater product selection to their customers.
Our analysis of supply chains indicate that, for a given level of sales, facilities for dedicated e-commerce distribution need to be larger than those for bricks-and-mortar distribution. Prologis estimates that every €1 billion of incremental e-commerce sales results in an additional 72,000 square metres of demand for logistics space, net of any cannibalization that may occur. What’s more, while online sales continue to grow rapidly, in-store retail sales continue to climb as well, benefitting traditional supply chains.
When companies are looking for high-quality facilities to serve their e-commerce requirements, they have a variety of options. There are the high-profile, build-to-suit projects but, at the same time, many companies are finding their needs also can be accommodated within existing logistics stock. The difference between e-commerce and conventional logistics facilities is the equipment inside, not the building structure.
New development in today’s marketplace remains low by historical standards, constrained by rents that have yet to broadly recover from trough levels. In fact, a high majority of the development that exists in Europe today is build-to-suit, or pre-let, activity. However, growing demand for new space has given Prologis the confidence to begin a measured program of speculative development in locations where there is high occupancy, stable demand and land ready to go.
Our research indicates that it is the ideal environment and time to be investing in Europe, and we are not on our own. In 2013, Prologis’ European funds – Prologis European Properties Fund (PEPF) II and Prologis Targeted Europe Logistics Fund (PTELF) – attracted €940 million of capital. With the weight of capital chasing a finite volume of available opportunity, values have started to recover and we would expect to see cap rate compression be a feature in our global markets. Beyond that, we believe the historic spread between logistics and office/retail will narrow, perhaps making it the perfect storm.
The long-term value of any real estate asset stems from its ability to meet the needs of potential users, and logistics is no different. Location is key, and some locations are simply better than others.
With logistics, quality long-term micro-locations and sub-markets can be identified and good buildings tend to have common features. Although there are many factors at play, it boils down to a simple formula: functional assets in “in-fill” locations at a sensible basis relative to replacement cost. These tend to stay leased better, benefit from demographic shifts and are less prone to any obsolescence.
That is the same underlying formula that drives the success of our business and supports the long-term growth our investors’ demand.