European Logistics under the Microscope, Part 1 Logistics 101

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1 FRONTIER

2 Jennifer Johnstone-Kaiser joined Frontier in January Jennifer leads our property manager research program and her responsibilities include investment research for clients, both domestically and globally. Jennifer has held many senior positions, most recently as Country Head and Director of Business Development with Savills Investment Management. Before this Jennifer was Mercer s Head of Real Estate - Asia Pacific, and worked with consultancy firm Pinnacle Property Group. Jennifer is a Senior Fellow of Finsia and a Women in Super member, and holds a Master of Finance and Bachelor of Business, Property (Distinction). Martin Thompson is a Senior Consultant at Frontier, having joined the firm as an Associate in Martin provides consulting support to a number of clients and undertakes investment and manager research. Prior to this Martin has worked in technology commercialisation at the University of Melbourne, virology research at Murdoch University and undertook a PhD in cancer research at the University of Western Australia. Martin has a Master of Applied Finance through Macquarie University, a PhD in Molecular Cell Biology and a Bachelor of Science with first class honours.

3 In November 2018 Frontier undertook an international research trip focused on the European logistics market. This paper (the third in the series focused on Logistics globally) is written in two parts: Part 1 Logistics 101 aims to provide an introduction to the sector, asset characteristics, locational attributes and its participants across the most significant European cities, as well as observations from our trip and considerations for client portfolios. Part 2 European Logistics under the Microscope, to follow in early 2019, will focus on the investment market for European logistics including drivers, market demand, the e-commerce shift fuelling that demand, rental growth forecasts, investment risks and opportunities, and implementation considerations for client portfolios. During the research trip, Frontier met with a number of managers active in the sector including Prologis, CBRE, TH Real Estate (a Nuveen Company), Invesco, La Salle and Aberdeen Standard Life. In Europe, e-commerce and supply chain reconfiguration, albeit lower than the US, are the key drivers of the logistics sector. When coupled with global trade and consumption, an unprecedented demand has emerged for new Class A space. 1 Anonymous

4 Industrial, warehouses and logistics are terms used interchangeably for a sector that provides real estate accommodation solutions for manufacturing, cold storage, spare parts and a variety of other services that need to interact between producers and consumers of goods and services. The primary asset type within the logistics space is warehousing. Managers focus on high quality buildings in superior transportation and distribution hubs in prime European markets. There is a range of characteristics that influences the type of tenants and flexibility of warehouse space. Some of these considerations are as follows: The optimal size will depend on the nature of the tenants in a region. For example, the optimal size of a facility in Fokker Park, a Prologis asset in Amsterdam was around 6,000 m 2. However, in most markets assets are likely to be Class A buildings with efficient configuration, typically 10,000 to 50,000m² and built post 1990 with a build-to-core component. A key consideration of this collection of warehouses is the ability to have multiple tenants providing considerable additional flexibility, including a small proportion of mezzanine and/or office components. Most managers we met focused on relatively standard warehouses (i.e. standard or cross dock facilities with minimum fit out) that are well located relative to transportation hubs. Some assets are built to suit (BTS) specific tenants or operations, which can mean non-standard building shapes or internal construction such as high loading mezzanine floors. Amazon is a notable tenant that often uses buildings constructed to its requirements, although only a small number of managers choose to have Amazon in their portfolios.

5 Warehouses come in a range of different configurations which serve different purposes. These include: Standard. These are typically rectangular buildings with loading docks on one side. They tend to be used for longer term storage or warehousing but can be used for a number of roles. Many of the facilities Frontier visited across Europe had a standard configuration. Cross dock. Typically, a rectangular building with loading docks on both sides. These configurations are becoming increasingly popular due to ease of access by large container trucks, and their turning capacity, and are primarily designed for reconfiguring loads in particular ways (consolidation or deconsolidation) before on-shipment, with minimal storage. Other specialised buildings can include multimodal facilities, such as those that directly take air or rail cargo and reconfigure for road transport. Ultimately, apart from locational choices, the structure, configuration and age of the building determines user attractiveness. Functional obsolescence is a growing risk in a sector undergoing rapid technological advancement and prospective tenants requiring newer facilities whilst facing accelerated rental growth conditions. This provides a tailwind to managers with sector expertise or nimble capital. Across Europe, Frontier visited a number of areas within the portfolios of Prologis, CBRE, Th Real Estate (a Nuveen Company), Invesco, La Salle and Aberdeen Standard Life. Multi-storey. Multi-storey facilities make optimal use of land in areas where land for warehouses is scarce or expensive. These are not yet a feature of the European landscape but have been widespread for many years in parts of Asia and are most likely to be used for last mile deliveries within major cities, driven by e-commerce. Specialised. Non-standard buildings include mezzanine levels, higher floor loading allowances, different dock locations and different building shapes. These are typically built to a client s specifications, with Amazon a notable operator experimenting with various specialised configurations which tend to generate a higher than normal yield (circa 4.0%). The specialised nature of the building creates re-leasing risk due to the inability to find a substitute conglomerate requiring an equal footprint.

6 Key areas within the logistics chain (and hence areas of demand for logistics space) include: Typically, large population centres with the level of consumption highly correlated with affluence. Paris is a key example of such a centre. Last-mile facilities are likely to become more common around such centres. Usually located near areas of industrial production for the purpose of storing and transporting the raw inputs and also finished goods. Fashion and industrial centres such as Milan fit into this category. Hubs that are integral to the logistics chain benefiting from strong transportation infrastructure (road, sea, rail and air), cost and availability of space. The Netherlands is an example of this category due to the Port of Rotterdam being the largest port in Europe. The Czech Republic is a beneficiary of the strength of the German logistics network with goods moved on to serve the consumption centres in Germany. Consumer demand for same-day delivery services creates immense pressure on logistics occupiers to find locations for distributions, centres and warehouses close to large population bases and flexible labour pools. These locations often are in inner city or city fringe areas. Transportation costs represent 40% to 50% of an operator s costs with rents being less than 7% to 10% of overall costs. Some managers interpret this as rents being an inelastic input as operators are able to offset lowered transportation costs against rising rents. A 2017 survey by Prologis 2 and eyefortransport (eft) established that 1% cost savings on transportation and labour potentially allows for an additional 15% to 20% in rent growth for logistics real estate. The same survey of 280 logistics users across Europe identified the top locational decision drivers, with countries such as Germany, the Netherlands and Poland ranking highly (Table 1). The location factor is the most significant consideration. For example, Frontier visited a logistics park located next to Schiphol Airport in Amsterdam. A large percentage of the tenants in the park were operating spare parts warehouses due to the easy access to air transport, allowing these parts to rapidly be distributed anywhere in Europe. Even the proximity to the airside (where goods are unloaded directly from aircraft) is a consideration for a warehouse located near an airport. Other locational considerations include the inter relationships between different tenants. One logistics park (in a CBRE portfolio) visited by Frontier has a large postal service as one of the tenants; an attraction for e-commerce players due to the ease of handing off parcels to the postal service. 2 Prologis and eyefortransport, 2017

7 The warehouse/logistics industry is highly regulated with locations constrained by environmental preferences of local communities who prioritise quality of lifestyle (commonly referred to as Not in my Back Yard or NIMBY syndrome). This often means large facilities are located on the periphery of a city, away from consumption areas, as municipalities take strong stances on congestion, pollution and aesthetics. We found Milan (and Italy, generally) to be an outlier in this respect with a variety of uses such as residential, agricultural, office and logistics commonly interspersing and spilling over into mixed-use locales. Generally, Western Europe tends to be much tighter on logistics zoning than Eastern Europe. Core cities of the Nordics, Germany, Ireland and UK, Benelux and France have much tighter planning regimes than Southern Europe and Central and Eastern Europe. While there is a push for last-mile facilities in most Western European cities located close to the consumption regions, mainly to service e- commerce, these need to tackle zoning regulation as well as the high cost of land. The positive from restrictive zoning is that it limits competition from potential new buildings, which can make existing assets and logistics zoned land more attractive, particularly for early movers such as Prologis which has accumulated land banks over the years. The key challenge for most competitors, unless they are wealthy locals, is entry pricing at today s valuations. Other regulation relates to the required characteristics of a logistic facility (such as fire and safety) and what can be stored within a warehouse. For example, warehouses in France, Germany and the Netherlands require certification to contain specified quantities and types of goods, with this audited annually by state authorities. This can restrict the types of tenants and non-compliance can result in a warehouse being shut down. Such regulation can be complex and onerous; hence manager expertise and vigilance are important. Most managers outsource this monitoring function to third party providers. The positive from restrictive zoning is that it limits competition from potential new buildings, which can make existing assets and logistics zoned land more attractive particularly for early movers.

8 Frontier toured a number of facilities where 3PLs are a dominant group operating outsourced logistics services for a wide range of different underlying clients. Hence the nature of the goods handled is variable as are the needs of the facilities tenanted. Often the underlying client of a 3PL. Tenants vary from supermarket chains to fashion and automobile suppliers. While still a type of retailer, e-commerce operators undertake a considerably higher level of handling of goods within the warehouses themselves. This includes the picking of goods and packaging for delivery. The handling of returned goods can also be a large part of operations for some e-commerce retailers. One study indicated that in the US e-commerce, retailers use three times the amount of logistics space compared to traditional bricks and mortar retailers. European investment volumes in 2017 were up 80% to 41.3 billion compared to 2016, suggesting values are stretched in pockets of the market. The region s logistics vacancy rate was below 5% in Q4 2017, down from 6% in the previous year (CBRE). Speculative development accounted for only 24% of the 132 million square feet under construction in Europe in 2017 (circa 12.3 million square metres), down 1% from In 2018, new speculative supply delivered to the market was expected to be slow, due in part to a scarcity of development land in many markets. Generally, the cross-section of tenants comprises of high quality and credit worthy domestic and international operators with lease terms varying from 3 to 9 years. The exception is circa 10 to 15 year lease terms for high-tech, e- commerce operators with sophisticated distribution robotics. Ultimately, apart from locational choice and where there are high barriers to entry and scarcity value, the structure, configuration and age of the building determines user attractiveness. Functional obsolescence is a key risk in a sector undergoing rapid technological advancement. New tenants requiring newer facilities are facing accelerated rental growth conditions. According to CBRE, prime logistics yields in Europe reached 5.3% in the first quarter of 2017, compressing significantly from the 7.9% figure it recorded in the fourth quarter of 2009.

9 Germany consists of dense logistics networks with the highest number of centres in Europe having global gateway status. Germany offers the deepest and widest range of investment opportunities in Europe; a mix of manufacturing, retail and 3PLs with easy access to the Czech Republic and Poland to the east, as well as Western Europe. Characteristics: Stock in sqm millions: 56 Investment volume per annum: 23 billion Vacancy rate: Very low Net initial yields: 3.9% to 5.25% Maturity level: Developed Opportunities: Expansion of logistics networks, industry Source: Fraunhofer SCS, 2017 and TH Real Estate, a Nuveen Company

10 France is the second key market in Europe; its location and North-South axis providing a powerful directional flow for natural logistics locations/hubs. The country s second ring of transportation highways, being connected from North to South in the lead up to the 2024 Olympics, should benefit the logistics sector. France suffers from relatively small logistics pockets in the west of the country whereas Tournan- En-Brie, less than 49 km to the South-East of Paris, is a major designated logistics hub Characteristics: Stock in sqm millions: 25 Investment volume per annum: 13 billion Vacancy rate: Moderate Net initial yields: 4.50% to 5.25% Maturity level: Developed Opportunities: Market size/liquidity, e-commerce Source: Google, TH Real Estate, a Nuveen company

11 The Netherlands is a key logistics hub for Europe. The Port of Rotterdam, Europe s largest and busiest harbour, is of enormous logistical importance for Europe, as is The Randstad region for access to the seaports and supply to the domestic Dutch market. The Venlo-Eindhoven-Breda axis links distribution to Germany and the rest of Europe. Speculative new construction is more common than in other markets and decline in global trade and Brexit are particular risks for the Netherlands. Characteristics: Stock in sqm millions: 21 Investment volume per annum: 10 billion Vacancy rate: Low Net initial yields: 4.25% to 5.25% Maturity level: Developed Opportunities: Liquid prime assets Source: Google, TH Real Estate, a Nuveen company

12 Italy is a developing logistics market with focus on the core markets of Milan, Bologna and Torino (Turin). Modernisation of logistics stock is essential to what is essentially an underdeveloped investment market. Strong municipal planning and sustainability constraints could be a barrier to entry. Characteristics: Stock in sqm millions: 14 Investment volume per annum: 4 billion Vacancy rate: Relatively low Net initial yields: 4.75% to 5.75% Maturity level: Emerging Opportunities: New buildings, strong manufacturing, e- commerce Source: Google, TH Real Estate, a Nuveen company

13 Warehouse preferences have changed over time and will continue to change in the future. This will impact the value of particular assets as demand increases for larger and more technologically sophisticated facilities as users consolidate their supply chain. Additionally, the cross-dock warehouse configuration is becoming more widespread due to evolving logistics practices and a growing focus on ESG (covered in Part 2). Omnichannel retail and the growth of e-commerce have been the primary drivers of demand during this current cycle. Consumer requirements for speedy service have forced everyone in the retail supply chain manufacturers, suppliers, distributors and retailers to carry more inventory in more locations. While the last mile/last Touch concept receives a lot of attention, we formed the impression that this sector is still very much in a state of flux in Europe. We believe the need for these facilities will continue to grow as e-commerce becomes more dominant but there is no standard European configuration yet. In our next logistics paper, Frontier will delve deeper into the drivers and metrics of the European logistics market, automation implications, future trends, where the risks and opportunities lie, and how a European logistics strategy can be implemented in client portfolios.

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