Posted by Macquarie Asset Management
18 October 2023
We believe market dislocation is producing a window of opportunity for real estate investors seeking exposure to logistics assets.
Demand for logistics space is growing rapidly as a confluence of global trends converge – rising ecommerce sales, consumer demand for faster delivery times, geopolitical reshoring of manufacturing, and post-pandemic inventory rebuilding.
But even as demand grows and rents rise, higher interest rates and capital market volatility are triggering refinancing and redemption pressure among some asset owners, who are selling down highly liquid logistics assets.
Meanwhile, a rise in building costs is impairing construction activity, leaving those that acquire logistics facilities today competing against less supply in the future.
In our view, this unusual combination of events may provide opportunities for industrial assets.
Logistics is a simple business at its core – efficiently distributing goods to households, retailers and businesses.
But the apparent simplicity hides a fast-growing, sophisticated and complex network of operations feeding an ever-more-demanding consumer.
Traditional mail-order timeframes have evolved into today’s fast-paced system of next-day, same-day, and even within-the-hour delivery.
But alongside the rapid growth of ecommerce, businesses are also investing in reshoring global supply chains and building inventories to protect against future shortages – further fuelling demand for warehousing space.
Ecommerce penetration jumped during pandemic restrictions and is now returning to pre-COVID-19 growth trends in the UK or growing off higher bases in the US.
But even as consumers return to physical shopping malls, online shopping is capturing a rising proportion of spending.
Sources: Bloomberg, BLS, PMA. As at September 2023.
To meet that demand, more modern logistics space is needed, which is typically underserved across markets, including Japan where occupiers continue to move to newer facilities.
Typically, ecommerce requires three times more logistics space relative to requirements for in-store spending, reflecting the wider variety of goods that need to be available for purchase and distribution of goods via multiple nodes.1
Leading the way are the big cities in Western markets – London, New York and Tokyo – where there is a dense affluent, urban population, with little patience for waiting for delivery.
Logistics operators are adapting to that change with large logistics facilities on the outskirts of major cities feeding goods to smaller infill facilities that can quickly meet demand.
The best large facilities are located near good transport and roads to allow goods to be moved efficiently from ports or manufacturing plants. The best smaller facilities need to be closer to customers.
Historically, industrial real estate was focused on providing facilities for local manufacturing firms.
Today, it is about storage, warehousing and distributing goods that have been imported, most often from different parts of the world.
The shift from an old-world manufacturing to a new-world logistics model has transformed industrial real estate investment.
But a transformation has also been underway within the logistics businesses themselves, which are gradually evolving into sophisticated, automated, high-tech operations, which is underpinning demand for modern logistics space.
Another emerging trend is the addition of solar energy generation to logistics facilities, particularly in markets that are less impacted by snow.
Auxiliary solar energy can be used to power existing occupier operations (often critical for highly automated facilities, which tend to be energy intensive), reduce carbon emissions or sell to the grid, creating an important new revenue stream.
Changing consumer behaviour is not the only factor driving the growth of logistics.
Businesses are increasingly facing up to the risks that geopolitical tensions pose to their supply chains and operations and exposure to any single supplier or market.
The COVID-19 pandemic highlighted the downside of just-in-time production, and now businesses around the planet are diversifying supply chains and on-shoring manufacturing, lifting the demand for warehousing and logistics facilities.
This is particularly evident in the US, where government subsidies are driving a surge in investment in technology like electric vehicles, batteries and semiconductors.
Even before the enactment of the US$53bn US CHIPS Act, semiconductor manufacturers were expanding their presence. Examples include Intel building new US$20bn chip factories near Columbus (Ohio) and Phoenix, and Taiwan Semiconductor Manufacturing Company developing a new plant in North Phoenix.2
In our opinion, this gradual retooling of Western supply chains, supported by governments seeking to reduce their reliance on foreign powers, will be an important driver of growth in logistics.
Source: Census.gov. As at July 2023.
Logistics businesses are also underpinned by rising inventory levels for all types of businesses as they lift the amount of stock they hold to ensure the empty shelves of the pandemic are not repeated.
A gradual shift from the old "just in time" inventory management towards "just in case" stockpiling is underway and further boosting industrial demand.
Source: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. As at June 2023.
Demand and rental growth for logistics space have historically been highly correlated to jobs growth and trade, though this relationship broke down somewhat during COVID-19 as online spending was brought forward.
Importantly, fundamentals remain solid relative to other core sectors, including office and retail. For example, the latest US national industrial vacancy rate is 5.2% against 9.1% for shopping centres and 13.3% for offices (excluding sub-leased space), according to CoStar.3
In the context of seeking exposure resilience through the cycle, we believe that healthy rental growth, good cash flows and the likelihood of continued solid growth make the sector attractive.
Source: Macrobond. As at September 2023.
In contrast to other key developed markets, accommodative lending conditions and positive leverage continue to support logistics pricing in Japan.
Attractive cash-on-cash yields and strong demand fundamentals are supporting demand for logistics exposure from domestic and foreign real estate investors.4 Furthermore, monetary policy is likely to remain accommodative as Japan grapples with demographic headwinds and underlying soft demand conditions as its population ages.
Should rates tighten over the next 12-24 months, for example to support a cyclical recovery in the currency, any tightening is likely to be quickly reversed when the global monetary easing cycle begins, and underlying demand conditions weaken.
According to JLL, demand for logistics space is now at cyclical highs reflecting the ongoing shift to online spending, consolidation of existing operations and drive for efficiency with occupiers shifting to newer modern facilities underpinning development strategies.5 Firms are also increasingly considering automation of their facilities to address labour shortages which is boosting demand for modern logistics facilities that can accommodate such shifts.
Rents are expected to continue to rise, reflecting a combination of higher land prices and construction costs which is putting upward pressure on prices for newly completed properties. Rising construction costs are also likely to impact development pipelines for weaker projects in non-core locations.
The rapid rise in interest rates over the past 18 months has reduced valuations and lifted financing costs across commercial real estate.
As a highly liquid asset, logistics space is potentially providing a route to reduce real estate exposure, lock in profits, meet redemption requests or wind down closed-end property funds.
We believe the recent capital markets volatility is creating attractive entry points. Refinancing and redemption events are also triggering sales of industrial facilities, despite their strong fundamentals.
In our view, the turnaround from the tight pricing and low cap rates during the COVID-19 period may provide opportunities in a market that is still experiencing very strong fundamentals.
Values in certain markets are starting to reset below replacement cost – a price point unseen since the global financial crisis6 and the current capital market volatility may provide an opportunity to rebalance.
Sources: Green Street, Bloomberg. As at September 2023.
Based on the acceleration in market rents in recent years our research shows that facilities with remaining lease times of up to three years are currently offering attractive upside potential.7
Market rents have moved strongly higher in recent years due to robust demand, tight vacancy conditions and positive economic tailwinds, adding between 15% and 40% in many markets.8
The rapid growth has left many assets under-rented just as the market is seeing sales pressure from owners facing refinancing or redemption pressure amid capital market volatility.
This may provide an opportunity to acquire short weighted average lease expiry (WALE) assets at attractive valuations for repositioning and re-leasing at higher rent with modest capital spending.
Source: PMA, CoStar, JLL. As at September 2023.
At Macquarie Asset Management, logistics has long been a target sector, but very tight cap rates have made it difficult for real estate investors to take a position in the core space.
Now, we believe capital markets volatility is creating an opening.
Even as institutional investors divest logistics assets, the outlook for the industry remains positive, with strong underlying demand driven by the growth of ecommerce and an ongoing deglobalisation of supply chains.
Amid the short-term turbulence, we believe tactical opportunities to take long-term positions at attractive valuations should emerge.
4 Globally, Japan remains the only key developed market where in-place stabilised cap rates are above "all-in" financing costs with industrial annual net absorption in the Greater Tokyo area at a historical high of 2.6 million square metres in 2Q23, according to JLL.
7 Data from CoStar, JLL and PMA shows that market rents began to lift sharply in key markets such as the US, UK and Australia during 2H20 and into 2021. Leases that were struck prior to this will be significantly under-rented relative to current market rents.
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