Solid indicators belie volatility in the logistics sector

Market fundamentals for the logistics real estate sector in the past few years have been remarkable by any standard. A combination of secular tailwinds and investor demand drove the sector forward with increasing take-up, record low vacancy, rising rents and compressing cap rates. The pandemic and lockdowns, despite their overall economic damage, pushed demand for logistics space even higher.

However, the sharp interest rate rises in 2022 and 2023 hit both occupiers and investors last year. Take-up fell as economies and supply chains slowed and logistics cap rates rocketed faster than they had fallen amid decreasing valuations.

Data from MSCI shows that global logistics performance as measured by its Global Quarterly Property Index, slumped dramatically, with annualized total returns in September 2023 of -5.5 percent, down substantially from a June 2022 peak of 35 percent. This compares with an annualized -4.5 percent for the all-property index in September 2023.

Moreover, the full effect of higher interest rates has yet to be reflected in prices.

AJ Jager, managing director and co-head, real estate Europe at Switzerland-based private investment firm Partners Group, says: “In 2023, the bid-ask spread was significant because there were very few firms with their backs against the wall with real distress and no alternative to accepting an offer.

“I believe 2024 will be the year where we start seeing more real estate owners who need equity solutions – mainly driven by upcoming debt maturities, having to accept what bidders are willing to pay.”

Craig Duffy, global head of fund management at global alternative asset manager GLP Capital Partners, contends that the strongest markets are close to stabilizing. “We’ve also been impressed at the strong operating resilience of our assets located in top-tier markets in the US and Europe,” he says. “Having mostly weathered aggressive cap rate expansion in these markets over the past 18-24 months from a valuation standpoint, we now see yields stabilizing and our view is that these locations are well poised to benefit if we enter an easing cycle and cap rates compress.”

Underlying performance in the logistics sector has been extremely resilient and has at least partially compensated for rising cap rates. Data from international real estate services firm JLL shows annualized rental growth in the third quarter of 2023 of 1.5 percent in Asia-Pacific, 3.4 percent in Europe and 4.2 percent in the US. These figures are all below the 2022 peak but nonetheless remain positive and higher than they were in 2019.

“We’ve cooled off on the leasing side in the last 12-18 months, but rents are still on an upward trajectory,” says Mehtab Randhawa, senior director, Americas industrial research at JLL.

Demand drivers remain

One thing market participants agree on is that demand remains solid, but it is also diversifying.

Melinda McLaughlin, global head of research at Prologis, a California-based real estate investment trust, says: “3PLs will still be a major source of logistics real estate demand, but leasing activity has become more diversified by industry in recent quarters. Specifically, manufacturers have increased investment in logistics networks near end consumers as one way to bolster supply chain resilience, and retailers are seeking to bring more supply chain control in-house to drive the focus on service levels.”

Reshoring and nearshoring trends in manufacturing are expected to have an effect on logistics demand, especially in the US and Europe, as manufacturers seek to de-risk supply chains by locating production closer to their customers.

“Investors continue to focus on locations which meet the needs of delivering to the
end consumer”

Melinda McLaughlin
Prologis

However, there is a lagging effect, argues Randhawa: “These manufacturing plants are massive projects, which are going to take a long time to build, unlike a typical warehouse, which gets done in nine to 10 months. But when they go live, they will generate demand for warehousing space.”

The reshoring trend has not diminished in the US. The number of companies mentioning “reshoring” in a quarterly earnings call was more than 200 in the second and third quarters of 2023, JLL/Bloomberg data show, compared with fewer than 100 mentions just one year earlier.

During the peak logistics period, the rising tide buoyed almost all markets, and the fall from that peak has been universal as well. However, those markets with strong barriers to entry and those with resilient underlying demand are set to outperform going forward.

Location, location, location

“Markets with fundamental demand and growth drivers for occupiers will outperform,” says Jager. “For example, around half of Europe’s international imports and exports go through Rotterdam and Antwerp ports, and in these locations, there will always be activity and occupier demand, even in a downturn. Secondary markets in southern Europe will perform when there is a strong economy and consumer spending but will be less resilient in downturns.”

McLaughlin adds: “Markets with the highest barriers to supply, deep and dynamic demand and competition from other property types tend to perform the best over the long run, such as Southern California, New York/New Jersey, South Florida, London, Tokyo, Toronto, Mexico City and major cities in Germany and the Netherlands.”

Location is set to be key for the sector in the next couple of years, Jager explains, adding that while real estate is always about location, this becomes even more crucial in volatile times, right down to the micro-location level.

The focus on micro-location is part of an ongoing flight to quality among occupiers, many of which are more concerned with overall efficiencies than rental levels.

Duffy says that logistics tenants will continue to prioritize having the right building in the right location to meet consumer demand for shorter delivery times and reduced costs.

This also means logistics occupiers, in common with other tenant groups, are preferring the most modern, efficient and ESG-compliant space. However, demand is still strong enough for lesser assets to benefit.

Randhawa says: “Demand for Class A is extremely high. Because time is money, occupiers want to get products in and out of as quickly as possible [and] so favor modern, efficient buildings. However, rents for good Class B buildings in Tier 1 cities are sometimes commanding very high market rents for renewals, comparable to Class A in some cases. This is a reflection of strong underlying demand.”

Property performance varies

The increased sophistication of the logistics sector means that it is hard to generalize about performance. There is a difference in rental performance between the various sub-sectors. Big box warehouses occupied by tenants that are very sensitive to consumer spending have underperformed other sub-sectors, such as urban logistics and small-bay industrial because of the occupiers’ need to be close to the consumer.

Meanwhile, other niches, such as outdoor storage and cold storage, have been resilient, but not universally. For example, cold storage rents in South Korea have been falling. UK-based real estate services company Savills predicted a 5 percent drop for 2023 due to an earlier supply boom.

Henry Giles, managing director, fund management at investment company ARA Europe says selectivity is important. “As a global manager, we see opportunities across the sub-sectors of logistics worldwide and believe that the sector continues to offer attractive risk-adjusted returns; although stock selection is key. Our highest conviction strategy in Europe is on the urban logistics sub-sector,” he says.

“We see that Western Europe is going through a similar change in occupier behaviors that we’ve already observed in the US and the UK, and that the impact on rental levels has only just begun. Factoring in the re-pricing in capital values that is ongoing in Europe in the sector, we’re of the opinion that 2024 and 2025 will be a very interesting time to capture this long-term occupational trend in European logistics at an attractive pricing entry point.”

Is it different in Asia?

The region has unique ingredients for growth

The Asia-Pacific region has been a leader in the logistics industry in many ways, pioneering multi-story warehouses, robotics and drones, but it also has markets with a combination of scale and growth which cannot be found elsewhere.

It also has interest rate outlier Japan, where the cost of debt has risen only minimally over the past 18 months.

Craig Duffy, global head of fund management at GLP Capital Partners, says: “Japan stands out as one of the stronger performing markets for logistics globally, largely due to its dovish interest rate policy stance, strong capital inflows benefitting liquidity and resilient asset-level operating fundamentals.”

While China has struggled to shake off the effects of pandemic lockdown and has seen foreign real estate investment grind to a halt, e-commerce has held up and high-tech manufacturing has also contributed to customer demand for logistics and industrial parks.

Duffy also sees potential in India, which he says is “poised to lead global growth in the next few years.” Alongside Vietnam, he notes India is set to benefit from shifts in global supply chain configurations. As both nations become manufacturing hubs, they will require substantial quantities of new logistics space.

Overall fundraising for real estate stalled in 2023. PERE data shows only $92.8 billion was raised across 139 funds in the first three quarters of 2023, representing a significant drop from the $150.4 billion raised in the same period in 2022. Multifamily, by comparison, accounted for 56.7 percent of the total capital raised for sector-specific strategies, while industrial only took up 36.9 percent of the total. However, relative to other commercial sectors, logistics fundamentals appear strong, and this supports continued investor interest in the sector.

“The long-term secular trends for the logistics sector remain intact and investor interest continues to be strong, both locally and internationally, as they view logistics as stable relative to other asset classes in a volatile broader market environment,” says Duffy.

“Sellers are prioritizing buyers with discretionary capital and certainty of closing over the highest price, and we believe this creates interesting opportunities for investment managers with discretionary dry powder.”

A more volatile market may be uncomfortable for some investors, especially those facing refinancing pressures, but it is also throwing up a host of opportunities. Some asset owners with refinancing or other issues are expected to be sellers of performing logistics assets because they expect more liquidity in the market.

“Investors continue to focus on locations which meet the needs of delivering to the end consumer. Locations with higher barriers to new supply often deliver better returns and, therefore, are more attractive,” adds McLaughlin.

Funding and construction fall

Occupier demand for modern, efficient space means there is an opportunity for investors to add value to assets with improvement or repositioning, or even redeveloping older assets facing obsolescence. This is especially the case for ESG improvements, which are needed to boost energy efficiency and to meet many occupiers’ ambitious decarbonization goals.

The pullback of banks and traditional lenders from real estate has created an opportunity for alternative capital and private debt to fill the void, says Duffy, and it is advantageous to have access to both local and international lenders and other sources of capital.

35%

Peak annualized rate of return of logistics properties in mid-2022

There was a sharp slowdown in logistics construction last year, due mainly to development cost inflation and reduced access to debt financing. There is also a reduced development pipeline going forward.

“Construction starts in the US are down 65 percent year-on-year, and the significantly fewer deliveries [slated for] 2024-25 bodes well for sustained rental growth,” says Duffy.
The next year or so will be about resetting the market and finding a new normal after a rapidly deflating bubble. On the occupier side, the recovery could be swift. Supply could become constrained quite quickly in some markets, especially those with limited land supply.

Adrian Ponsen, director of US industrial analytics at real estate data provider CoStar Group notes that construction starts for logistics projects have been falling since the summer of 2023 and are now at 10-year lows. By 2025, current projections show that very few new projects will be completing construction, as an after effect of the pullback in groundbreakings that has already gotten underway. This means that even a small uptick in leasing next year would be enough to cause the market to tighten and support a reacceleration in rent growth shortly thereafter, he explains.

Randhawa says: “A recurring theme that I heard from colleagues in Europe was lack of buildable land, however, competition for land is a worldwide theme… This means that by the end of 2024, or early 2025, we could again get into a supply crunch situation in some markets across the globe.”

ESG a priority for occupiers and investors

Upgrading properties is part of future-proofing strategy

Both logistics occupiers and investors have ambitious net-zero emissions targets, which means ESG-compliant assets are favored; lower costs are welcome, too.

Even companies such as Amazon, which is targeting net-zero carbon by 2040, will welcome short-term cost savings that could come from lowering last-mile delivery costs, which can account for 41 percent of the total shipping costs, according to research from Deloitte and Chinese logistics firm Cainiao.

Melinda McLaughlin, global head of research at Prologis, says: “Green-certified and future-ready buildings, for example with roofs prepared for solar or electric vehicle chargers, will become increasingly important to help decarbonize supply chains.”

Meanwhile, ESG enhancement is now a key consideration for many investors, according to Craig Duffy, global head of fund management at GLP Capital Partners. This could lead to longer hold periods and more investment in obsolescence-averting capital works.

Large logistics assets lend themselves to solar PV installations. Hong Kong-based ESR has more than 100MW of solar PV installed and plans to install 1GW of solar capacity across its portfolio by 2030.

Logistics owners are also investing in EV charging, better insulation and even hydrogen-powered vehicles – pioneered by ESR in Korea. Meanwhile, the difficulty in recruiting in the logistics sector means the social aspect of ESG has come to the fore and space is increasingly being developed with better facilities to attract better employees.