The week in review

The week in review

• In the past decade, global investment in the industrial & logistics real estate sector has increased fourfold. While once the purview of small privates, manufacturing firms, and other owner-operators, it is now dominated by major institutions and global money managers. In 2012, the sector attracted just 12.4% of global capital directed towards commercial real estate. Just a decade later, that figure had risen to over 23%, as the likes of Blackstone and Prologis competed with GIC and Brookfield for the best assets, in a ‘who’s who’ of global investors.?

• Investors were attracted to this once unpopular sector by strong secular tailwinds, underpinned primarily by shifting preferences in the way that we consume goods, and by disruptions to the way those goods are supplied to us. They have been well rewarded for this conviction; returns in the industrial & logistics sector have significantly outperformed other sectors in recent years.?

• At the beginning of this year, capital continued to flow into the sector; total investment in the first half of 2022 was 12% higher in comparison with the same period last year, and more than double the five-year pre-Covid average. This contributed towards further yield compression; the average prime yield across Europe reached a cyclical low of 4.1% in Q2, with the best performing assets transacting at sub-3% yields.
• However, sentiment has shifted quickly in response to a rapid repricing in debt. Given the very low starting point for yields, the arithmetic in the industrial sector is perhaps harder to justify than in any other sector at present. Investment volumes have declined by nearly 30% year-on-year in Q3 as a consequence, with many investors taking a step back. In some of the hottest markets, such as Germany, pricing became very difficult to negotiate, and numerous sales processes were aborted because buyers and sellers could not bridge the differences in their expectations.
• Across Europe, we have already shifted our benchmark prime yields, implying a 10-20% decline in asset values in most markets. The good news is that, globally, borrowing costs have stabilised in recent months, which should provide some clarity for investors going forward and put a cap on yield movements.
• But the other consideration is occupier demand; cap rates are generally modelled as a function of both interest rates and expectations for income growth. And demand is likely to moderate in line with the slowdown in consumer spending and retails sales of goods; across OECD countries, growth in retail sales volumes has all but stagnated. This dynamic is already starting to play out across logistics markets; in the US for example, leasing activity fell below 200 million square feet for the first time in 2 years in the third quarter.?

• Against this backdrop, there is the (literally) growing issue of unsold inventories. As we’ve highlighted previously, in the past 12 months, firms across major advanced economies have invested significantly in boosting their inventory holdings. This was in response to a series of bottlenecks in global supply chains; building resilience to future shocks was most easily achieved in the short term by switching to a ‘just-in-case’ supply chain model, requiring more stocks of key intermediate inputs and final products.
• Given that the global economy was still recovering from the Covid-19 induced recession, this was considered a relatively low-risk strategy. Supply chain managers were confident that these inventories would not go to waste; back in October 2020, when inflation was still ‘transitory,’ and Russia was bluffing over Ukraine, the IMF forecast global economic growth to be 4.2% in 2022 and 3.8% in 2023. These inventories needed storing somewhere, and so occupational demand for warehousing surged; in Europe, logistics take up in 2021 was nearly 37% higher than in 2019 (pre-Covid).
• But the economic outlook has shifted dramatically since. In their most recent update in October, the IMF again revised down their forecasts for world growth, to 3.2% and 2.7% in 2022 and 2023, respectively. This is mostly underpinned by a much weaker outlook for consumer spending as the cost-of -living crisis intensifies. In the UK, the Office for Budget Responsibility expects household disposable incomes to fall by 7% in real terms over the next two years; the largest decline since records began in the 1950’s. This is a problem for many retailers; in the US, retail firms are sitting on nearly US$750 billion of stock, which is up by more than 22% on the year. Large firms such as Target, Walmart, Gap, and Nike have all highlighted issues with their inventories in recent earnings reports.
• Meanwhile supply chain pressures continue to ease as bottlenecks are resolved and world trade growth slows. Freight costs are returning to pre-crisis levels. So after all the shortages in goods last year, we now face a glut of supply. In the US, shifting supply and demand dynamics resulted in used car prices falling by 2.4% month-on-month in October alone, based on the latest inflation data. For similar reasons, household furniture was down by 1.2%, and clothing by 0.7%.?

• All this means that we are at a cyclical peak in inventories, and so it difficult to see how, in the current environment, major retailers will be taking on more storage capacity. If anything, occupiers are likely to reduce their requirements, or attempt to sub-lease existing space, especially given margins are being squeezed by higher wages, energy prices, and rising warehousing costs. Weaker demand for space will naturally translate into weaker income growth in the future.
• But investors are not turning away from logistics; indeed our recent survey of major investors across the Europe and Middle East region suggests they remain enthusiastic for the sector. One supporting factor is scarcity of product - as we highlighted last week, scarcity is also important in supporting interest in prime office markets. However, given some of the structural tailwinds coming out of the pandemic, developers have responded faster to shortages in industrial product, attracted by rising rents and falling yields. In markets such as Japan, the US (particularly in sun belt markets), and India, this has underpinned concerns that the onboarding of supply will increase vacancy rates in the next few years, reducing the pricing power of landlords in future rental negotiations. Although vacancy rates around the world have fallen to such an extent that the market can accommodate more free space without necessarily hitting rental growth too much. And in Europe; logistics development is facing competition from the residential sector for land, while the big box market faces difficult with zoning and permitting laws.
• A second factor investors are taking into account is that the logistics sector has strong ‘fundamentals’ – a catch-all term used to describe the structural drivers of growth, and often a useful segue for property researchers to give a positive story even during the most challenging of times. In the case of logistics, the positive secular story is supported by a belief that e-commerce will continue to grow market share around the world , while alternative uses such as data centres provide both diversification in tenants and exposure to high-growth industries. Investors are also betting on nearshoring as a structural driver of demand in the future.?

The week ahead

• It’s a relative quiet week ahead, although I’m sure it will be anything but, judging by recent weeks. In Asia, the central bank of South Korea is meeting to set policy. They are likely to hike rates again, but it will be interesting to see whether they signal an end to the tightening cycle . There is also inflation data published in Japan, Singapore, and Hong Kong. In Europe, regional consumer confidence data is available. And in North America, Canada publishes retail sales, while in the US, as well as the latest on jobless claims, we have some housing market data covering new home sales, mortgage applications, and building permits. Finally, the flash November PMI activity data is available for major advanced economies including the US, UK, euro area, Japan, and Australia, and the US Federal Reserve publish the minutes from their last meeting.?

Market monitor

• After strong gains across risky assets last week, markets were more circumspect this week. US policymakers were keen to stress that, as the English saying goes, one swallow does not make a summer. In this case, the message was, one good CPI print does not make a pivot. Short-dated US Treasury yields rose as a consequence, but longer dated yields were unmoved. The yield curve is deeply inverted across most combinations; markets are pricing in a recession in the US, and so hawkish comments from officials merely adds to this narrative. Asian equities were buoyed by news that Chinese authorities will loosen their grip on the real estate sector, offsetting some caution around rising domestic Covid-19 cases. In the UK, markets were largely unmoved by the governments autumn statement, suggesting normal service is restored.?