The success of the European logistics sector is driving capital well beyond the continent's prime locations, as Monika Bukowska reports

Prime logistics properties are now featuring more on investors' radar screens. This has escalated noticeably over the last year, especially as modern warehouses still look relatively appealing for debt-backed investors given the positive yield gap for this segment of the market, despite the rise in finance costs in recent months. Although modern logistics warehouses are a relatively new component of many portfolios, recent developments indicate that the sector is well positioned to provide attractive returns to investors going forward.

In Europe, this growth has been underpinned by improved macroeconomic conditions and the acceleration of international trade. The underlying market dynamics have seen the growth in demand for modern logistics solutions where there is an increased focus on cost efficiency, and ongoing cost reductions in an increasingly competitive global industry. Alongside this, the rapid growth of the contract logistics market in Europe has seen increased demand from logistics operators for larger and more flexible warehousing, given the diversity of their clients and products. This in turn has seen the rapid development of real estate outsourcing in the warehousing sector, with growing pressure on logistics operators to focus on core activities, reduce debt and return capital to shareholders.

Strong investment demand for logistics property has been reinforced by the general re-pricing of real estate as an asset class, forcing down yields and boosting capital growth and total returns. Returns for industrial property, including logistics, have been very healthy compared to the euro-zone All Property average.
A record €20bn was invested in European logistics property during 2006, almost double 2005. This represented 8% of cross-border real estate investment transactions across the continent, up from 6% in 2005.

A recent investor intentions survey by Cushman & Wakefield showed just under 10% of investors targeted logistics property during 2006, but 14% expected to do so this year. Investment volumes already point to record volumes being achieved in 2007, €25bn worth of direct property transactions in the sector likely to be closed by the end of the year. The search for yield and for suitable stock is continuing to fuel the appetite for the product, and increasingly investors are looking to emerging opportunities in less developed markets, such as provincial cities in Poland. Another route is through corporate acquisition, exemplified by ProLogis's acquisition of the developers, Parkridge, and Goodman's purchase of Rosemound.

Strong investment demand has contributed to a higher turnover of assets, a rise in the number of sale and leaseback deals, and the forward funding of logistics developments by investors keen to acquire stock. Occupier demand for these new developments has been aided by a push by logistics operators to upgrade their facilities, releasing obsolete, older warehouses which increasingly struggle to compete in terms of technical specification, security and compliance with environmental legislation. This has led to higher levels of take-up for Grade A space. Outsourcing of logistics activities by corporations to specialist third party logistics providers (3PLs), has grown at an annual rate of 10-15% in Europe over the last 10 years. Demand from 3PLs has similarly focused on modern, flexible buildings.

Logistics is increasingly perceived as a suitable institutional investment sector, with secure covenants, high quality developments and greater investment market liquidity. There has been a narrowing of yield differentials with office and retail space, although modest rental growth expectations mean a differential will remain. Also, increased cross-border activity by investors and occupiers, and the emergence of new logistics hotspots in the industrial growth areas of central Europe, have narrowed the spread of yields across European markets - a process Goodman believes has further to run.

2007 will see strong, double digit returns for many European logistics markets. Cross-border activity will continue to drive pricing as investors seek to diversify domestic market performance, and to broaden their pool of assets. When capital growth eventually slackens as the current re-pricing runs its course, investors are likely to favour markets offering an attractive income return. Although the sector has lost some of this advantage in this area, industrial property, and logistics warehousing in particular, seems set to remain a more important part of investment portfolios than was the case historically.

Goodman's forecasts suggest that logistics property will outperform offices in many European markets over the next three years, helped by a higher income return and a closer match between demand and supply. However, despite the closing performance differentials between the sectors, generally modest rental growth prospects mean performance is likely to lag retail.

Although capital growth is set to decelerate sharply, and has already done so in the UK, Goodman expects European industrial property returns to deliver a respectable annualised return of nearly 9% for the years 2007-2009. Markets leading this performance include the Netherlands, France, Germany and parts of Italy. At the other end of the spectrum, Austria will suffer from lower cost competition from further east. As yields become more demanding, central European warehousing will marginally under-perform against the euro-zone average.

Logistics occupiers will continue upgrading their space requirements, and demand for larger, more efficient properties will be sustained. However, this will lead to an emergence of a new tier of obsolete, secondary space in maturing markets.

New supply, especially of large warehouses, will continue to focus on less established, but accessible locations, given the mounting land prices and lack of large sites in prime locations. Rising occupier demand and tight margins, will encourage large warehouse occupiers to look seriously for more cost-effective logistics sites, if not new markets. Germany and Austria are still suffering competition from their eastern neighbours, despite rising labour and production costs in these locations.

It remains to be seen how much more margins can be squeezed for both occupiers and developers across Europe, especially in an environment of spiralling land costs and low vacancy rates. There are already signs of upward rental pressure in top logistics locations, which is likely to become more pronounced.

The key ports in western and southern Europe will attract further growth, especially those with deep sea access and plans to extend their capacity. Secondary airports will also see growing interest from both occupiers and developers during 2007.

Beyond the established core European logistics markets, expansion at the margins of central and eastern Europe will continue. This is already starting to embrace the new EU markets of Romania and Bulgaria. There has also been growth in occupier demand in the Ukraine (most notably around Kiev and to the west closer to the Hungarian border) and Russia, which has largely focused on Moscow.