The European industrial and logistics market has been recovering since 2013 and has been particularly strong in the past year. With yields at all-time lows and capital values above previous peaks in some markets, where are we in the cycle and how much further does it have to run?
Where are we in the cycle?
Prime logistics yields continued their downward trajectory last year, to reach an all-time low of 5.6% in Q3 2017. Indeed, average yields are below the previous peak in all real estate sectors, with prime office below 4% and high street retail as low as 3.2%.
Obviously, they are also significantly lower (by 30-40%) than the yields at the bottom of the cycle in 2009. This is largely a function of official interest rate policy that has produced record low bond yields across Europe.
Record investment volumes
Yield compression has also been driven by the strength of investment volumes that have seen four consecutive record breaking years for logistics, although the wider property sector (ex-UK) has had a similar recovery from the trough.
Logistics volumes exceeded the record level in 2016 in the first half of this year alone. At €30 billion, total volumes for the first nine months of 2017 were also nearly double the ten-year average of €15.5 billion. Even if we adjust for the €12.25 billion Logicor deal in Q2 2017, investment volumes in the first 9 months of 2017 were still up 21% YoY, with Spain, Germany and the UK exceeding their previous peaks.
The sector clearly became a core institutional asset class for global investors and sovereign wealth funds last year, attracting €41 billion of capital in the year to September 2017, half of which came from outside the European region. Inevitably this has driven down property yields. Logistics yields remain at a premium over other real estate sectors and the spread over German bunds is still above 5%.
Nevertheless, logistics capital values have seen significant increases since 2009, ranging from 7% in Italy to 68% in France. By year-end 2016 they had reached as high as €1,850/sqm in Sweden and €1,650 in the UK. Capital values are forecast to continue rising in the majority of European markets over the next five years. This is largely driven by rental growth that is expected to offset the limited increases in yields forecast during the period.
Another positive for the sector is that debt levels are substantially lower than at the previous peak in 2007. Average gross LTVs were c.46% at the end of 2016, compared with 73% at the previous peak and 37% at the trough in 2009. On top of lower gearing, interest costs are significantly lower this time, with bond yields at record lows and all-in debt costs still close to the historic trough.
Supportive market fundamentals
The fundamentals of the occupier market continue to be supportive, with low vacancy, driven by strong leasing activity. Vacancy remained below 5% at the end of the 3Q this year, sharply lower than the previous trough of 7%. Completions have remained strong at c.5% of the total modern stock in 2017, but take-up has continued to exceed new supply. In the core European markets completions are expected to remain in a similar range relative to existing stock.
As a result rental rates have been recovering strongly. However, average prime rents are still not back to the peak levels in 2008 and have only been rising for the past three years, after a prolonged downturn. Also, rental rates have only exceeded the previous peak in half the core European markets. As a result, we forecast annual rental growth to remain strong over the next few years, ranging from 0.5% a year in Paris to 3% in Madrid.
What are the new drivers this time?
Other than technological advances like robotics, which are ongoing, the main difference in this cycle is the way the growth of e-commerce is reshaping supply chains. The internet’s proportion of retail sales across the EU continues to increase.
The UK currently leads the way at 16% and is expected to reach 22% by 2022, according to Euromonitor, but the rest of Europe is also expected to see continued growth in internet penetration. This and the consolidation of logistics service providers in the search for economies of scale, has driven the move to larger and fewer warehouses.
The reason this is so positive for logistics real estate is that e-tailers typically require up to three times the warehouse space that a normal bricks and mortar retailer requires, as well as a greater need for urban or last mile logistics. As a result, the estimated additional warehouse space required over the next four years is in a range between 16m sqm and 23m sqm, for e-commerce alone.
Macro backdrop is supportive
The macro outlook is improving, as European GDP growth forecasts are upgraded, driven by the continued recovery in global trade and private consumption. Unemployment is also falling. The Eurostat EU economic sentiment indicator remains positive and GDP is forecast to strengthen relative to other regions, including the US, even if interest rates start to normalise this year.
What is the outlook?
Therefore, the outlook for the European logistics sector remains positive. The macro outlook is improving, although there is always a risk that the usual suspects (inflation, monetary policy mistakes and external shocks) could trigger an end to the cycle. Generally, Europe is still in recovery mode and logistics markets are starting to accelerate.
It would be naïve not to expect property yields to follow bond yields higher in due course and we would expect this process to start in 2019; however, the impact on the sector’s capital values should be largely offset by rental growth.
By Mark Cartlich, Senior Director, Industrial & Logistics, Capital Markets, EMEA, and Jack Cox, Head of EMEA Industrial & Logistics, Capital Markets.
This article first appeared in EuroProperty.