Standard Life Investments

Focused Insight

Shopping online suits logistics just fine

More of us are shopping online, which makes life easier and more convenient. It also makes for a more competitive and fast-moving battleground for retailers and creates disruption among real estate markets. The recent bankruptcy of Toys “R” Us highlights this, with the company failing to deal effectively with the rise of e-commerce. Financial-services firm Cowen expects US consumers to make 41% of their purchases of toys and games online in 2017, around double the amount bought over the internet in 2009.

Retail’s pain is industrials’ gain

While the move to online shopping is having a somewhat negative effect on the high street, it is having a more positive impact on another type of real estate – industrial buildings that deal with logistics. The industrial real estate sector has undergone structural change over the last 10 years or so. Traditional retailers re-shaping their supply chains, third-party logistics companies and the inexorable rise of e-commerce operators have driven demand. Amazon, for example, has dominated logistics take-up in the UK over recent years, as it looks to build capacity into its supply chain.

This surge in demand for logistics means that the industrial sector has driven commercial real estate performance globally. Indeed, industrial real estate outperformed the allproperty benchmark in nearly every region during 2016.

As more institutional investors began investing in industrial properties, prices increased, driving capital growth. However, that is not the whole story. In the 30 global markets measured by MSCI in 2016, industrial assets had the strongest income returns in 18 of them. Landlords have pushed rents higher because industrial real estate is at, or near, historically low vacancy levels in most of the world’s markets. In the US, for example, when compared to its own performance history, logistics real estate is by far the healthiest property type, with vacancies one-third lower than the last cycle’s best reading. Given that context, it is not surprising that logistics has had the strongest rental growth of any US property type for 15 quarters in a row.

Is there room to grow?

With industrial real estate having enjoyed a prolonged period of outperformance, the question for investors now is whether growth in e-commerce will continue to spur the sector. In our view, there is still plenty of room for improvement.

While e-commerce sales are still just a fraction of retail sales globally, growth far exceeds the rest of retail. In addition, distributing directly to an internet consumer is much less efficient than delivering to a bricks-and-mortar store, requiring over twice as much space for a given amount of sales.

Therefore, even as e-commerce eats away at other retail sales, there is built-in upside for logistics demand. According to large industrial REIT Prologis, just over 10% of space globally is currently dedicated to e-commerce, so there is quite literally plenty of room to grow.

Staying ahead of the game

Many logistics companies are also employing increasingly innovative distribution strategies in order to meet demand effectively and efficiently. This includes making better use of existing industrial space through multi-storey design. Multifunctional facilities are also becoming increasingly common. Here, design flexibility is key, as industrial space combines with emerging sectors and activities such as bioscience, digital media and fashion design.

Finally, the ability of companies to fulfil ‘last mile’ delivery is another key success factor. With more people living in densely populated areas in and around cities, the concept of the sharing economy may result in urban consolidation centres (logistics facilities situated close to the areas they serve). These types of initiative illustrate that demand for logistics is unlikely to diminish any time soon, although the methods of delivery will change.

Proceed with caution

As we look ahead, the market cycle for industrial real estate is relatively well advanced and pricing on prime assets is very competitive. As a result, choosing the best assets in the right locations is vital if investors are to continue extracting optimal returns. Despite this caution, the rise in e-commerce presents myriad opportunities and is one of the main reasons that logistics markets are likely to remain at the top of the ‘shopping’ list for many institutional real estate investors in 2018 and beyond.