The end of logistics’ golden age?

    Cap rates have increased sharply in both Europe and the US. But logistics experts argue that strong fundamentals will support a return of investment activity later in the year.

    Even compared with a turbocharged 2021, the logistics real estate market looked like it had discovered a new gear in the first half of 2022. Industrial overtook multifamily to become the most popular segment for sector-specific funds, attracting $13.6 billion of capital, according to PERE figures. Logistics specialist GLP alone raised three of the 10 largest funds closed over the period.

    But observers were already starting to ask questions of a market beginning to look overcrowded and expensive, even before a series of interest rate rises by the US Federal Reserve and European Central Bank aimed at curbing rampant inflation dampened spirits. By the end of the summer, some market commentators were willing to concede that real estate’s hottest sector had peaked. Others, however, saw only a blip caused by the same macro-economic factors that have put pressure on real estate as a whole, one which would soon pass given logistics’ strong secular drivers and enduringly sound market fundamentals.

    Cap rates have adjusted sharply in recent months. Industrial brokers and managers in both the US and Europe say that yields have increased by around 100 to 200 basis points depending on the individual market. “Bottom line, higher interest rates mean lower values across the whole equity stack, including real estate, and logistics is not immune from that,” says Peter Ballon, global head of real estate at Canadian investor CPP Investments.

    Logistics yields have moved out further than those for some other assets classes, notes Jack Cox, head of EMEA industrial and logistics capital markets at CBRE. “That is logical because of the forward-looking nature of those cap rates.

    “They were growth-implicit and were subsidized by low interest rates and negative bond rates. Yields came down very low, so it is natural that we would see a more pronounced adjustment in prime logistics.”

    The sudden fall in capital values has stalled the industrial sector’s headlong momentum. “The market has moved into less liquidity,” says Laurie Lagarde, head of the EMEA logistics operator division at CBRE Investment Management.

    “Since the summer, some investors have paused investing in real estate in general, and in logistics as well, while they see how the macro situation will improve, before they will come back to the market.”

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    Varying outlooks

    Inevitably, a gap has emerged between buyer and seller pricing expectations, which is expected to suppress investment activity. “We have a shortage of sellers willing to take the pricing discount, particularly those that bought in the last 24 months,” says Jason Tolliver, logistics and industrial co-lead for the Americas at Cushman & Wakefield.

    “We expect less velocity in the investment sales market than we have experienced in the last two years. I would anticipate a relatively slow start in the first half of the year, particularly if there is a recession.”

    While industrial markets in the US and Europe have faltered in recent months, the adjustment has not been replicated evenly around the globe. Stuart Gibson, co-chief executive of Asian logistics platform ESR, says that cap rates are no longer compressing across most of the region, and have softened by 25 to 50 basis points in Australia and South Korea. However, in China, where central bankers have resisted raising interest rates, and particularly in Japan, the picture is very different.

    “Japan, in a nutshell, is business as usual,” Gibson says. “Demand is very strong. Interest rates are still low. There is a lot of money trying to get into Japan, and that is probably going to keep driving cap rates down. Right now, they are at 3 percent for prime. They will probably be 2.5 percent by the end of the summer.”

    “Higher interest rates mean lower values across the whole equity stack, including real estate, and logistics is not immune”

    Peter Ballon
    CPP Investments

    Meanwhile, cap rates in emerging markets like China, Brazil and Mexico have barely moved, notes Joseph Ghazal, global head of capital deployment at Prologis. But higher interest rates have impacted capital flows into US and European logistics property, he says, in part because the rapid adjustment of public markets has left some investors over-allocated to private real estate due to the denominator effect. “Some will potentially have to reallocate their portfolios, and maybe reluctantly exit logistics assets to come back to ratios that are more in line with their strategy.”

    Capital inflows to the sector have slowed, he observes. “Investors are on the sidelines, waiting for things to settle down a little bit. It is not really about redemptions, it is about less new money coming in while investors wait for pricing to come down. The investor appetite is still definitely there. But they are trying to figure out what is the right moment to get back in.”

    Michael Neuman, head of industrial for the US and Latin America at Ivanhoé Cambridge, says that the Montreal-headquartered real estate investor intends to keep growing its global logistics portfolio. “Today, we are managing C$70 billion ($52 billion; €48 billion) in assets globally, so we cannot be contrarian and opportunistic with everything we acquire. We need to find the next area of growth, and compared to retail and offices, logistics offers a better outlook.”

    Nick Cook, president of GLP Europe, admits that fundraising conditions have changed since the firm’s record start to 2022. But he adds: “I wouldn’t by any means say that the tap is off. Indeed, there are still a decent number of investors out there who see the same strong fundamentals on a long-term basis.

    “I have never known the disparity between occupier and capital markets to be as significant as it is right now. In the first three quarters of 2022, we had our best leasing activity on record. We leased 1.5 million square meters across 60 different transactions in our European portfolio. Today, our nearly eight million square meters of space is 99.3 percent occupied. They are statistics that tell the story of a very active occupier market.”

    New logistics construction likely to reduce in 2023

    Emphasis will shift from speculative construction to build-to-suit

    Developers are likely to slow construction activity in 2023, reducing the risk of potential oversupply, even in the face of potentially weaker occupier demand. Prologis research predicts a 60 percent decline in development starts across its US markets, to less than 175 million square feet this year, and notes that quarterly starts have already fallen by 30 percent from their peak.

    Major developers’ speculative building programs are likely to be scaled back. “Build-to-suits will be very much the flavor of this year,” says Prologis’ global head of capital deployment Joseph Ghazal. “We will be maybe a little more cautious on speculative development in the first two quarters.”

    The rising cost of development finance has rendered less well-capitalized players unable to build, observes GLP Europe president Nick Cook. He says that GLP will continue to build new space in Europe, although it will likely adjust its approach in some markets.

    “We will continue to develop a mix of spec and build-to-suit, although the ratios of those may become more balanced to about 50-50. In the last couple of years, we have trended more towards 80-20 or 70-30 in favor of spec.”

    Cost increases present an ongoing challenge, says CPPIB’s global head of real estate, Peter Ballon. “Inflation is a serious risk for construction. If material and labor costs get too high, there is no longer an economic return for building new logistics, and we won’t do it. The key is making sure that you underwrite accurately.”

    “Development still works in good locations, if you can get the land,” argues Logan Smith, head of European logistics at Hines. “A year ago, for a good site an agent would have three bids coming in at 20 percent above the normal value at which it should trade. Now you would get one or two bids at that normal level, and one or two below, so the best bidder wins. That is not unhealthy. It is just the return of a normal equilibrium in the market.”

    No fear of the future

    Occupiers have shown voracious appetite for logistics space recently. But will that continue? Tolliver notes that while e-commerce-related demand has plateaued somewhat following a period of frantic expansion during the pandemic, online traders are still expected to take a growing share of the retail market. Meanwhile, onshoring and the shortening of supply chains means that manufacturers and third-party logistics firms have taken up the

    Tolliver says that the US saw over 550 million square feet of net occupier growth in 2021. In 2022, that fell to around 460 million, which was still much stronger than any other year on record. “We anticipate having around 237 million square feet of net growth in 2023 and another 200 million in 2024,” he says, “so although the rate of growth will likely be half those all-time historic highs, we will continue to see positive net absorption leasing activity.

    “We are entering into an economic slowdown with the tightest market conditions ever. Vacancy is anchored at all-time lows in virtually every major market in the US. As a result, even though we have seen slightly less robust leasing activity this year, rent growth continues to accelerate.”

    The US vacancy rate stands at just over 3 percent, and is much lower in prime coastal markets, where rental growth has often been astonishing. “In the past 18 months we have seen increases of 30 percent, 50 percent and even 80 percent in the California Inland Empire,” says Neuman.

    “As a landlord, when vacancy is below 5 percent you can drive rent growth. In some markets like the Inland Empire there is almost no vacancy at all. Small companies are sometimes worried about what is happening to the market. But companies with bigger operations that need buildings of 500,000 square feet-plus have funds, and they are less afraid of the future.”

    “We are entering into an economic slowdown with the tightest market conditions ever”

    Jason Tolliver
    Cushman & Wakefield

    Managers are adapting their strategies to the new situation. In recent times, assets have often been rolled up into portfolios. That has changed, says Cox. “The portfolio premium was driven by positive financing conditions. With the withdrawal of that helpful financing, there is greater focus on
    single-asset deals.”

    Higher debt pricing is having another effect, he adds. “Debt is, in many cases, no longer helpful to delivering the required return, so we are seeing that return being made up with a larger component of equity, or maybe pure equity. There has been a convergence between the levered return and the unlevered return, with a correspondingly sharp focus on logistics fundamentals: location, credit, the quality and specification of the lease, particularly in terms of inflation hedging.”

    With yields no longer falling across the board, in a potentially recessionary environment, some locations and assets will find themselves more exposed than others to worsening conditions, says Ballon. “There were times when the market was not differentiating between good-quality logistics and lesser quality,” he says. “But it is starting to make that differentiation, and it will grow going forward. Now, more than ever, is the time to make sure you have the best-quality assets, because those will thrive in any market.”

    There may be opportunities for managers to acquire at a discount as pricier borrowing starts to bite. “Some developers overstretched on land at the peak, and are signed up to build-to-suits they can no longer deliver because financing costs are much higher, and they are a little bit underwater with valuation,” says Ghazal.

    Neuman adds: “Some situations will need to be refinanced in the next 18 months and won’t be able to solve their debt obligations. While they are not distressed as such, they will need to sell, whereas if they had kept the assets for another 24 or 36 months, they would probably have got better value for them.”

    The pinnacle of logistics’ golden era appears to be behind us. “It would be naive to think that pricing will revert to what we experienced in in 2021-22. It will find a new level more firmly moored to economic and real estate fundamentals,” predicts Tolliver.

    However, many investors are confident that strong occupational demand together with constrained supply create good prospects for rental growth. As a result, market participants on both sides of the Atlantic expect investment activity to ramp up again in the second half of 2023.

    “The fact that yields have gone up will give us more opportunities to invest when there is more certainty,” says CBRE IM’s Lagarde. “I expect everybody else out there will do the same.”