Key expectations for the European logistics market in 2023
Despite inflationary pressures and economic headwinds, occupier market fundamentals remain strong, with positive rental growth expectations underpinned by a continued demand-supply imbalance.
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Returns are coming under pressure due to softening yields. Inflationary pressures and economic headwinds are denting consumption and weighing on business sentiment. However, occupier market fundamentals remain strong, with positive rental growth expectations underpinned by a continued demand-supply imbalance.
Further repricing expected in 2023 in some markets
The 10-year Eurozone Central Government Bond yield has risen quickly over the past year. At the end of Q4 2021 it was 0.28%, by the end of Q4 2022 it was 3.00%, a movement of 272bps. It has since risen further and now stands at 3.22% (end of February 2023) as compared with the 10 year German Bund of 2.64%, which will put further upward pressure on real estate yields.
According to the MSCI Quarterly European Index, the European industrial net initial yield was 3.58% at the end of Q4 2021, expanding just 78bps to 4.39% at the end of Q4 2022. This has resulted in shrinking the spread, or “premium” offered by European industrial real estate relative to bond yields. At the end of Q4 2021, the spread (between European industrial yields and Eurozone Central Government Bond yields) was 330bps, at the end of Q3 2022, it was just 80bps – an historic low. It has risen to 139bps at the end of Q4 2022.
Some markets are much further ahead in pricing discovery
In the UK, prime yields moved out c.175bps in 2022. Prime logistics yields for London now stand at 5% and prices in the UK are now showing signs of stabilisation. However, the ECB has been slower than the Bank of England in terms of rate rises and some EU markets are further behind in their repricing journey.
Across the key prime markets, we have seen yields soften an average of 100bps year-on-year. All European industrial markets have recorded structural yield compression over the past ten years, with the rise in ecommerce underpinning rising demand for high quality facilities, along with longer leases, higher levels of cap ex and stronger covenants.
Gap between pricing in prime and secondary markets will increase
Prime markets will continue to see interest from investors as they direct their focus on secure income and fix their sights on well-located, best-in-class facilities, underpinned by strong lease covenants. The prospects of a softening economy with weaker rental growth prospects and higher default risk will have a greater impact on secondary markets and investors will demand a higher spread.
Investment activity set to improve throughout course of 2023
The disparity between buyer and seller expectations has weighed on investment transactions in Q4 2022 and with debt often no longer accretive to cash-on-cash returns, the weight of capital targeting the logistics sector reduced. Debt costs are expected to rise further and will continue to restrict activity from investors reliant on leverage as prime logistics yields remain too low to meet the coverage ratios they need.
Even well-capitalised buyers have been delaying decisions in the face of continued uncertainty along with expectations of further price shifts. However, the sector remains a key target for real estate investors, with pricing expected to stabilise in the second half of 2023, we expect investment activity to pick up.
With fewer buyers, well-capitalised investors are able to benefit from less competition and lower prices. Sector specialists should be well placed to raise capital and take advantage of opportunities as the market shifts. Dislocations in the market could present opportunities for funds still in their commitment period with funds to be drawn.
Heightened interest rates are also impacting corporate borrowing rates and as rates rise, the impact will become more acute. Owner-occupiers wishing to raise capital may find borrowing costs prohibitively expensive and may look to offer up their facilities through sale-and-leaseback arrangements as an alternative.
Headwinds for occupational market
If inflation does persist, it will continue to erode household incomes which will in turn impact demand, particularly for larger purchases. This could impact regions particularly dependent on manufacturing. There is a significant automotive industry presence in Germany as well as in the CEE markets (including Czech Republic, Poland and Slovakia) and these markets could see a pullback in demand from their occupier base.
Fundamentals of sector remain strong
Low vacancy rates will insulate the market from the impacts of any potential fall out in the occupier market, while the supply-side response remains stymied by build cost inflation, heightened financing costs, with high land entry prices and softer exit yields. These factors continue to put upward pressure on rents.
Despite a pullback in demand from online retailers during the second half of 2022, the growth in online retail will continue to drive demand over the longer term. Average online penetration rates in Europe declined slightly in 2022, as lockdown measures eased. However, the fall in penetration rates was most marked in those economies with the highest penetration rates, such as the UK, Germany and the Netherlands.
Although many markets have penetration rates below 15% and most of these markets recorded year-on-year growth in penetration rates, as their online markets evolve and logistics operators continue to develop their distribution networks across the region.
Investors will need to look to income to drive returns
Uncertainty around inflation and economic growth over the next few years mean that investors will need to be selective in their choice of assets. While rental growth is broadly anticipated to outpace inflation, this will not be the case for all assets/markets and the margins are likely to be narrower than we have seen in recent years. Real estate tends to perform poorly in an environment of stagflation, with inflation driving assets into over-rented positions while market rents lag due to a weakening occupier market.
A focus on tenant covenant and quality of income will be important for investors looking to shield themselves against these downside risks. Getting a good inflation hedge (via good indexation clauses), accessing reversion and active asset management will therefore be crucial to driving returns over the next few years.
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