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Real Estate

Delivering the goods to investors

By Luke Dixon
Head of Real Estate Research - Real Estate Sydney, Australia

Traditionally the logistics/industrial sector was underpinned by heavy manufacturing, resources and storage industries. However, since the early 1990s the sector has been evolving, relying more on services and technology-led growth. The pace of change was supercharged through COVID-19 by the forced reliance on online consumption and changing consumer preferences, underpinned by universal mobile and cloud-based technology. Global growth drivers such as e-commerce, supply chain automation, technology-enabled retail and now post-lockdown economic rebound are providing ongoing strong tailwinds for the surging logistics sector.

All these global macro themes are driving market fundamentals in the logistics sector. According to JLL Research’s data on take-up of industrial leases, more than 70 per cent of leases signed in 2020-21 were from sectors directly related to e-commerce and online fulfilment, compared to just 30 per cent in 2008-09. Logistics and industrial is a case study of how a sector, that was broadly seen as ‘big sheds’ aligned to old economic drivers, can completely transform into something contemporary, relevant and growing in importance within global institutional portfolios.1

Demand continues to outpace supply across all markets driving record levels of rental growth Historically, industrial and logistics markets have seen relatively benign levels of rental growth, with a long-term annual average of 1.8 per cent2. However, since 2015 rental growth has accelerated sharply across most developed markets, particularly in inner Sydney and South Eastern Melbourne.3

Across all forms of real estate, rental growth is a function of demand vs supply. Unsurprisingly, rental growth is stronger when occupier demand exceeds new supply and weaker when occupiers have increased choice. Our research indicates for logistics, the relationship is strongest if rents are shifted forwards one year (takes time for conditions and sentiment to filter through to leasing activity).

From 2007-2020 across Sydney’s industrial precincts there have been 47 instances where annual occupier take-up exceeded annual supply completions and 24 instances where supply exceeded occupier demand4. Vacancy is a factor; however the data series is less developed compared to office so historical relationships are harder to ascertain. With prime vacancy currently at low single digits, the flow through from excess demand to rents is expected to be strong5.

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The supply chain-reaction

Supply chain structuring is a critical component in the economics of logistics assets, as tenants look for the most efficient transport locations in densely populated, urbanised markets. Occupiers are now looking at logistics in a similar way to retail tenants, with a view to catchments, transport access and consumer depth.

For logistics operators, the standard supply chain model sees rents accounting for an average of 5 per cent of total business costs, which is small compared to transport, labour and inventory which accounts for 85 per cent of the fixed cost base, with transport being the highest6. Optimising transport efficiency through strategic investment in locations with better access to transport infrastructure will create opportunities to increase rents, whilst enabling tenants to make significant savings in their transport costs.

For example, Sydney Inner West rents are $152/sqm, Outer Central West rents are $130/sqm7. If revenue doesn’t change, to maintain an occupancy cost ratio of 5 per cent an Inner West site would need to enable transport cost savings of -1.7 per cent compared to the Outer West i.e. every 1 per cent reduction in transport costs allows for a 10 per cent increase in rent. A combination of transport cost savings and increased revenue would result due to a larger customer base and more efficient delivery routes, with the additional revenue providing better coverage of fixed costs.

Warehouse efficiency is also a factor – newly-developed sites can better support automation which reduces labour costs. The major supermarkets are taking slightly different approaches. Coles is focusing on large, automated, highly efficient distribution centres further removed from the customer base. Woolworths is more focused on micro-fulfilment centres which can deliver efficiently in higher density locations and also facilitate click & collect options. The large distribution centres will assist in reducing picking costs, while the micro centres may deliver better delivery cost savings.

The supply chain effect is likely to intensify demand for smaller format, inner urban ‘last mile’ logistics as e-commerce levels are likely to go above 20 per cent. The experience in the UK and US markets, where e-commerce penetration rates are in excess of 20 per cent, shows that large distributors start wide, with larger, lower-cost facilities and gradually narrow into the inner metro areas to meet faster fulfillment times. Sydney and Melbourne, the two largest cities in Australia, will likely see this phenomenon first as competition for consumers wallets intensifies.

3PL Operator – Third-party logistics operator Source: AMP Capital Real Estate Research, CBRE Research, JLL Research
3PL Operator – Third-party logistics operator Source: AMP Capital Real Estate Research, CBRE Research, JLL Research

Tight cap rates here to stay | Strong fundamentals and investor demand push pricing to new peaks Core logistics pricing is reaching new peaks displacing traditionally more expensive sectors such as office and retail. The reasons for the tight pricing and relative outperformance is due to a confluence of factors.
Firstly, global investors have been reallocating investment portfolios towards logistics for the past decade, as e-commerce growth, technology adoption and supply chain efficiency have created new drivers for the sector and have underpinned higher income growth.8

Secondly, rental growth is now materially higher than in past cycles, with market rents for core product delivering 3 per cent plus face rental growth over the long term, a 30 per cent-50 per cent premium over the long-term average9. Given the low capex costs associated with industrial and logistics, this accelerated level of rental growth is directly boosting income returns and minimising reversionary risk. The narrowing in negative rental reversion, where market rents are achieving parity with fixed rental reviews, is enabling investors to price assets more aggressively than in past cycles and driving cap rates and passing yields to new record levels.10

 

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Finally, insufficient supply of quality product versus the intense weight of capital demand is resulting in sharp competition for assets. Against a backdrop of modest supply growth this is likely to continue over the medium term.11

As Sydney and Melbourne cap rates sharpen, and Brisbane now following, high quality product with long WALE12, is now in the low 4s to mid 3s – comparable to markets like London, New York, Chicago and Los Angeles. Total returns are still running strongly, with 20 per cent plus returns in the year to June 2021 according to MSCI.

This high level of return is largely a product of strong capital growth and is perhaps unsustainable over the longer term. We are forecasting returns to remain elevated and attractive to institutional investors in a low-interest rate investment market, with Australian assets likely to achieve a market wide average annual total return of 9 per cent plus over the next 10 years.13

The sector is not immune to downside risks including inflation, however, historically the oversupply of product through speculative development, sharp falls in tenant demand and poor location selection have all resulted in sharp pricing corrections.
 

1. Real Capital Analytics
2. JLL Research, 10-year average
3.JLL Research
4. JLL Research
5. JLL Research
6. AMP Capital Real Estate Research, CBRE Research, JLL Research
7. Source: JLL REIS, June 2021
8. Real Capital Analytics
9. JLL Research
10. AMP Capital Real Estate Research
11. AMP Capital Real Estate Research, JLL Research
12. Weighted Average Lease Expiry
13. AMP Capital Real Estate Research

 

 

 

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Luke Dixon | Head of Real Estate Research, Real Estate, AMP Capital
  • Covid-19
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  • SMSF News
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