Savills

Research article

Logistics: The bubble…deflates

‘Logistics continues to be a high conviction sector for investors. There remains a compelling narrative supporting this view; underpinned by shifting trends in the way we choose to consume goods, and where they are produced. But the sector has exhibited bubble-like behaviour in recent years; investors have scrambled to gain a foothold in the market, encouraged by exceptionally strong occupational demand and the resultant rental growth since the pandemic. Higher interest rates have underpinned a large repricing in prime assets, but the bubble need not burst; demand and supply dynamics will support stable or growing rents across most markets, with extremely low vacancy rates insulating the downside.’



2022 was another very strong year for the logistics sector. Investment volumes totalled US$ 269bn globally, which despite falling by 21% in comparison with 2021, still represented a 30% increase on pre-pandemic levels. This contrasts the trend across offices, where transaction volumes were down on 2019 levels across all regions. As such, slowing momentum over the course of the year was more a reflection of a normalisation across capital markets, as opposed to a fundamental retrenchment.

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Nevertheless, the sector is not immune to wider macro trends. Landlords have benefitted from a disrupted supply chain; at the peak of the cycle, the best assets in core locations across the US and Europe would transact at yields below 3%. This was fine when the risk free rate of return was close to zero and there was US$ 18tn in negative yielding debt washing through the global financial system. But as rates began to rise, these low yields quickly became untenable, and logistics could not avoid the upward shift in valuations we have seen more generally, regardless of what was happening in occupational markets.

In Australia, mainland Europe, and the US, prime asset values declined by 10-20% in 2022. But this is unlikely to represent the bottom; despite moving quickly at the beginning of the cycle, the period of price discovery may last longer for logistics. Sellers are reluctant to offload assets that continue to perform, and lenders will be more accommodative at future refinancing events (given better long term fundamentals), reducing the level of distressed sales that would mark the market lower. The UK market has moved faster and is arguably nearing a bottom, with the 35% decline in valuations already piquing the interest of investors again.

The tailwinds that have propelled the sector forward in recent years are not necessarily reversing, but they are moderating. Much like the office sector, some occupiers, particularly pure-play retailers, find themselves with too much space on their hands; not due to a structural decline in requirements, but rather a result of bringing forward future growth plans during the pandemic. Some re-balancing and right-sizing of requirements are to be expected. Investors will need to overcome recency bias when returning to the sector; the return to ‘normal’ market conditions represents a downshift in market dynamics, requiring more practical assumptions on future income growth.

The end of the space race

In the aftermath of Covid-19, global businesses invested heavily in building resilience by increasing inventory holdings, replacing the familiar ‘just in time’ with ‘just-in-case.’ Across the G7, businesses accumulated more than US$ 1.1tn in inventories through the 12-month period to Q3 2022. These inventories needed warehousing, supporting almost insatiable tenant activity. In the US, some coastal cities effectively sold out of space as a consequence. In Hong Kong, the logistics sector became a local safe-haven for capital due to the resilience in occupational demand (the vacancy rate was just 1.9% in Q4 2022).

But these inventories were also predicated on a stronger outlook for consumption. While logistics was traditionally the purview of manufacturing and trade, retail spending is now the primary driver of take up (Chart 14). A consumer-led economic downturn will weigh on tenant requirements as firms run down excess inventories. Supply chains often over-react to swings in retail sales – a phenomenon known as the ‘bullwhip effect’ – which could exacerbate the downturn in occupational markets.

There are other ways to boost resilience in supply chains, and a new world of geopolitical uncertainty will support momentum around nearshoring production. This trend is gathering momentum across advanced economies; in the UK, take-up of manufacturing-related firms in 2022 was 73% up on the long-term average. In the US, legislation is supporting ‘strategically important’ sectors with large logistics demands, including semiconductor manufacturing and EVs. But this is a slow moving process, unlikely to offset a cyclical slowdown in leasing activity. China is embedded into global supply chains, and retains a competitive advantage due to its mature infrastructure. There are also alternatives for manufacturers still engaged in a race to the bottom. Vietnam offers a lowcost production base that is also a relative ‘geopolitical safe-space,’ central to the ‘China plus one’ strategy.

India has also benefitted from supply chain rebalancing; warehouse and factory prices in Mumbai rose by around 10-20% in 2022, and continued inbound investment from global manufacturing is likely to support growth of 5-10% per annum over the next few years.

Nearshoring is also incompatible with ‘just-in-case’ in terms of warehousing demand; locating production closer to the final market can facilitate a return to lean inventory management. Deglobalisation also means less global trade, implying reduced requirements for the transport and storage of traded goods.

E-commerce over sold

The pandemic-era spike in online penetration is proving less persistent than many expected, as consumers returned to physical retail as mobility restrictions were relaxed (Chart 15). In mature e-commerce markets such as the UK, US, and South Korea, online penetration has returned to the prepandemic trend. Occupiers are reassessing their needs accordingly. Amazon, often cited as the barometer for the occupational market, is returning sublease space to the market in the US and Europe. In the US, net absorption was nearly 30% down on the year in Q4 2022 and 20% down on the long term average, mostly driven by weaker demand from e-commerce platforms. Vacancy risk is rising across some sun-belt markets (Phoenix, Dallas/Fort-Worth, Atlanta etc.) where speculative development was highest.

No room at the inn

The slowdown in occupier demand needs context. Growth in e-commerce remains a long term structural tailwind for the sector; not least because of the ‘build it and they will come’ philosophy adopted by major retailers in the aftermath of Covid-19. In Asia Pacific, there has been more persistence in online sales across underdeveloped e-commerce markets, particularly in Japan and Singapore.  

 

Firms are also more comfortable holding larger inventories in this cycle given the recent economic disruption (Chart 16). Nearly 40% of occupiers who responded to our 2022 European Logistics Census plan to increase the quantity of stock they hold over the next three years. And logistics space is very accommodative for alternative, high-growth sectors, supporting a diversity in tenant demand across areas such as data centres, electric-vehicle supply chains, and deep tech. Singapore for example, while exposed to a slowdown in global trade, should see continued demand from alternative sectors such as precision engineering and biomedical. By contrast, the options for repurposing office space are much more restrictive.

Meanwhile, supply dynamics remain largely supportive for investor returns. Prime quality logistics is still favoured by core/core+ investors as a consequence, although location is an increasingly important differentiator between assets. ESG credentials are also growing in importance given rising energy costs and labour shortages. In the UK, take-up for second-hand units accounted for just 22% of leasing deals signed last year, a record low.

In Europe, prime logistics in France, Germany, Netherlands, and Spain have historically low vacancy rates, and speculative development is expected to decline. Shorter lease lengths will be favoured by investors, providing some reversionary upside in rents in a landlords market, which is important given the direction of travel on yields.

In the US, construction starts fell by 40% between Q3 and Q4 last year, and there remains plenty of appetite for properties in key gateway markets of Southern California, New Jersey, and South Florida, where vacancy rates are below the US average of 4%, even though rental growth is expected to slow sharply from the highs of 40% plus last year.

Across the Asia Pacific region, Australia and Singapore are the most supply-constrained markets, with a vacancy rate of around 1% in the former expected to support solid rental growth of 4-6% this year.14 In Japan, investors are more cautious as further onboarding of new stock and cost sensitive tenants weigh on rental growth prospects. And there are also oversupply concerns in South Korea, although the development pipeline is slipping due to rising construction and financing costs.

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