Logistics real estate markets around the world strengthened in 2014, thanks to more customers being in expansion mode, tightening occupancies and rising rents. In 2015, the cycle will advance further into expansion, although several themes will shape the year.
Of note, the U.S. again will lead in the major logistics markets. Europe will advance gradually and see ongoing development activity in emerging markets.
The uptick in global development activity is driving up replacement costs. In time, this will require higher market rents, and e-commerce will become an increasingly important part of the picture.
The US Leads the Way
The United States leads in diversity of new customer requirements, rent growth, increasing development activity and maturation of e-commerce supply chains. Major coastal markets, and those in Texas, were the strongest during the past few years. Larger properties of than 500,000 square feet enjoyed stronger demand than smaller facilities of less than 100,000 square feet.
Overall, the improving U.S. economy has translated to broader demand for logistics real estate. Customer activity has improved in a greater range of size categories and in markets such as Atlanta and Nevada. According to Prologis’s proprietary Industrial Business Indicator, this trend is likely to continue in 2015. (The IBI measures customer activity levels, which are at their highest since the market recovery began.)
Demand has outpaced supply for the past six years, a trend that should continue through the coming year. Vacancy rates have fallen, making quality facilities difficult to find. Users must be proactive when addressing upcoming requirements — starting earlier and making faster decisions. Rental rates have surged, a significant recovery from recession-era losses. Initially, rent spikes occurred only for larger properties in major coastal markets, but they now occur across a broader swath of property types and locations. Above-inflation growth should continue for another few years because of low vacancy rates, but will normalize as supply and demand come into better balance.
Logistics markets are in the early innings of e-commerce demand. Traditional retail store activity is being transferred to distribution facilities, which can accommodate higher inventory levels, greater product diversity and direct-to-consumer shipping. Despite high-profile transactions above 1 million square feet, growth among smaller customers is notable. A significant number of retailers with $100 million to $750 million in annual online sales will be tomorrow’s billion-dollar online retailers. Such growth will prompt changes to supply chain organization — for example, a transition from a tendency toward centralization to localization, creating added demand near major population centers.
Higher occupancy levels and rental rates will support a wider range of development activity. Earlier in the recovery, build-to-suit projects dominated development. Recently, speculative developments have become more common. This activity has advanced gradually — new demand still exceeds supply in most markets. While product scarcity remains, we’ll see pockets, such as in Dallas and Southern California, where demand and supply are in better balance, which in turn will allow users to more easily fulfill their requirements.
Even Europe Will Expand
Europe’s logistics recovery has lagged, but the cycle is advancing, supported by structural demand drivers and depressed development levels. Positive demand for Class A assets has overcome subdued economic growth as customers upgrade from older facilities. Although demand is below normal, supply has been depressed for six years and comprised mostly of build-to-suits. As a result, market occupancy has risen to 92.1 percent, up 90 basis points from a year earlier and higher than the pre-global financial crisis.
The recovery, led by the U.K. and northern Europe, has been fragmented. But a combination of structural demand drivers, such as the rise of e-commerce and consolidation, plus improving macroeconomic growth across the continent appear to be driving activity across a wider range of markets. E-commerce customers have been even more active than they are in the U.S. Although competition for vacancies across most customer types on the continent isn’t intense, markets are tightening, and users soon may need to address upcoming requirements earlier than in recent years.
Emerging Markets Overcome Challenges
Growth of logistics real estate in emerging markets is driven by changes to retail formats and supply chains. The increased emphasis on and rapid growth of e-commerce is a recent and added positive. As a result, logistics operating fundamentals have outperformed the choppy macroeconomic climate. Occupancies for bulk distribution facilities are elevated in major logistics markets, including in China, Mexico and Brazil.
Development will remain a key theme in emerging markets. Not only is demand elevated, but these markets also are immature and underserved. A metric such as total Class A logistics stock per person illustrates this point. Most emerging markets have fewer than two square feet per capita (the focus here is on the middle class versus the whole population). More advanced emerging markets, such as Mexico City, have five to 10 square feet per capita. Developed markets, such as global U.S. markets like Los Angeles, Dallas and Chicago, have 10 to 25 square feet per capita.
Development Costs Increasing Rapidly
Elevated logistics development inflation isn’t too surprising. Prices for most inputs, such as land, labor and general contractor pricing, were depressed during the financial crisis, although they are recovering. The best example is Japan, where replacement costs have risen by about a third in the past few years, whereas the broader economy has seen relatively limited price increases. In the U.S., replacement costs have increased 5 to 7 percent in each of the last few years.
This expansion of development costs affects a user’s ability to source quality properties. As costs rise, developers will have to charge higher rents. This could delay construction starts, if only for six to 12 months. Construction delays exacerbate the lack of vacancy, and this theme is likely to be more pronounced in 2015 than in 2014.
Conclusion
The logistics real estate expansion will mature in 2015, and customers and investors must be nimble and forward-thinking. The U.S. faces an acute shortage of vacant properties, and customers are advised to act in the most efficient way possible to secure the best real estate.
In Europe, the logistics market is tightening gradually, and the dynamic could tip more quickly than flat macroeconomic headlines suggest, because the U.K. has been one of the most improved markets in the past year, notwithstanding only recent and modest economic momentum.
Activity in emerging markets continues to grow, and e-commerce buoys growth across all markets.
The global expansion of construction activity supports a normalization of pricing for development, leading to outsized inflation and, possibly, higher rents in time.
Chris Caton is vice president of research for San Francisco-based Prologis, the world’s largest industrial real estate company. Contact him at ccaton@prologis.com.