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March 15, 2023

Timber buildings – Cost-competitive sustainable real estate

In 2022 we released our report on timber construction titled “Timber Buildings – Truly sustainable real estate”. This demonstrated the many benefits of construction using mass timber (short for massive timber) when compared to traditional steel and concrete.

To recap, the benefits of using mass timber include:

  • Energy efficiency: manufacturing mass timber materials uses significantly less energy than steel and concrete production;
  • Faster construction: prefabricated timber panels enable shorter construction timetables than building with steel and concrete thereby reducing construction-based emissions;
  • Less disruptive: fewer delivering trucks are needed resulting in less disruption to communities around building sites;
  • Resistant: mass timber is fire-resistant and avoids moisture damage when built correctly; and
  • Financially attractive: rising occupier demand for greener buildings led to a 9% rental premium for timber buildings.

This report seeks to look more closely at the amount of carbon reduction during the building development and lifecycle. It also explores how the cost implications of timber buildings compare to steel and concrete.

The full report can be found by clicking here.

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February 15, 2023

Polish appeal: Europe’s most dynamic country should be a focus for savvy investors

Poland’s performance prospects are compelling. In our view it is being unfairly discounted by investors due to its proximity to Ukraine. We also believe that it is set for sustained occupier demand growth due to the strength of long-term fundamentals related to economic growth and demographics. A combination of rising occupier demand increasing rental potential, a lack of space suitable for modern businesses and a flawed perception of risk creates a powerful impetus for savvy investors to seize the chance today to acquire good quality real estate and benefit from superior performance tomorrow.

In the first article of this series, we explore why Polish investment prospects are so compelling. In future articles we will examine the performance opportunities presented by individual real estate sectors.

Risk perception: Extreme caution towards Poland is misplaced

International investors have shunned Poland since the Ukraine invasion given its proximity to the conflict and its high associated risk perception. Polish real estate investment volumes in H2 2022 were 35% down on the five-year average according to RCA (figure 1). Polish prime yields have moved out between 50-90 bps over the last year and it remains one of the highest-yielding European markets (figure 2).

Polish-real-estate-investment

Prime-yields-in-Poland

Logical reasoning implies that this heightened risk perception is misplaced. Indeed, far from being an inhibitor of future performance, proximity to Ukraine is likely to be an accelerator of it.

Our baseline assumption is there will not be a horizontal escalation of the Ukraine conflict in which Poland is invaded. Given Russia’s battlefield setbacks, their inability to retain territorial gains and the assertive, unified position of NATO and the EU towards Russian aggression, we believe such escalation is highly unlikely. If such an escalation did eventuate, we would all have far more to worry about than real estate values in any case. In the medium-term (the next five years), we also assume that the conflict reaches a settled state and active combat ends. Accepting that, let’s turn to the real estate fundamentals.

 

Economics and demographics: Dynamism in leading occupier demand indicators

According to Oxford Economics, Poland will benefit from some of the strongest economic growth in Europe over the next five years (figure 3). Because such growth is a leading indicator of occupier demand, this bodes well for real estate performance. However, we believe that even these bullish growth assumptions may be too pessimistic as they fail to account for the full impact of Poland’s post-war relationship with Ukraine.

Economic-projections

Poland has been a hub for shipping arms and aid to Ukraine over the last year. Post-war, it will be the conduit through which the reconstruction effort is funnelled. Given the damage Russia has inflicted – the reconstruction costs are estimated by the World Bank amount to €322 billion so far – that effort will be significant. There is talk of a new Marshall Plan, the American programme that turbo-charged Europe’s economic recovery after the second world war. Poland’s leading role in the reconstruction effort will be solidified by the international creditability it has gained by virtue of its resolute response to the invasion. This will translate into far greater foreign direct investment (FDI) from international capital once the risk perception declines.

Poland has been a haven for Ukrainian refugees, with 7.5 million fleeing across the border according to the European Investment Bank. Some 1.5 million are estimated to remain there today, many of whom are likely to settle permanently. The presence of so many additional people has caused some immediate tensions by exacerbating pressure on housing and social infrastructure. Short-term challenges aside, these immigrants will inject dynamism into Poland’s demographic profile by adding labour and population. The new arrivals tend to be younger and better educated than the average Pole. It will be an attractive destination for corporate occupiers seeking to tap that plentiful, affordable supply of skilled labour.

Current forecasts do not, in our view, fully account for the additional economic and demographic growth impetus associated with these factors which will directly translate into stronger real estate demand.

 

Conclusion: Unwarranted risk and solid fundamentals make Polish real estate an investment gem

In summary, we believe that the Ukraine-related risk of Polish real estate investment is over-estimated. We also consider that economic and demographic growth drivers will stimulate sustained occupier demand in the medium-term and long-term. Investors who access the market now can secure assets and development sites aligned to future demand and associated rental growth at higher yields than will be available once the Russian-Ukraine conflict settles. Exposure to capital and income growth potential will, if executed correctly, deliver out-performance. That is why we are so optimistic on Polish real estate.

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October 11, 2022

The impact of rising interest rates on real estate yields

Alex Dunn, Research Manager, Cromwell Property Group

Interest rates tell you how high the cost of borrowing is, or how high the rewards are for saving. So, if you are a borrower, the interest rate is the amount you are charged for borrowing money, shown as a percentage of the total amount of the loan. In 2022, interest rates have risen across Australia, Europe and the US.

The relationship between interest rates and real estate yields is important for investors to understand, given the potential impact of the former on the latter.

While we believe that recent interest rate increase will place upwards pressure on real estate yields, our research implies that other real estate fundamentals are also important, and theses will limit the extent of yield softening.

Statistically, our analysis shows there is a very close relationship between 10-year government bonds and real estate yields.

Government Bonds: Closely correlated with real estate yields

Government bonds are viewed as proxy for the ‘risk-free rate’, which is the theoretical rate of return for an investment that has no risk of financial loss. An increase in interest rates encourages saving and deters borrowing and in so doing raises the required rate of return for real estate investment.

In figure 1, we compare Eurozone government bonds to prime Eurozone office yields. A score of 1 means two variables are perfectly correlated, meaning they move in unison. A correlation of 0 means there is no relationship between them. The correlation between Eurozone government bonds and prime office yields over this period is 0.89. This implies a strong relationship and the long downward trend in real estate yields since 2001 is heavily linked to the fall in interest rates.

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Change-in-prime-office-yields

Although there is a strong correlation between the two variables, the magnitude of moves in real estate yields and bond yields has differed significantly over the past two decades. Figure 2 shows that real estate yields fell by an average of 280bp across major European markets from peak to trough, while bond yields reduced by 495bp over the same period. This suggests that real estate yield movements, although in line with bond yields, are far less volatile and are subject to other forces.

Figure 3 shows the spread between prime UK office yields and 10-year government bonds, and we have used data from the UK office market due its stable history. The spread at the end of 2021 was around 476bps, compared to the long-term average of 306bps. While there is no mathematical rule to indicate the spread which can trigger repricing, we believe the bond yield must first rise to reduce the spread to levels comparable with the long-term average before exerting direct upwards pressure on real estate yields.

UK-prime-office-yields

Figure 2 also shows that since 1992, there are two periods where the spread between UK prime office yields and 10-year government bonds significantly reduced: between 1993-7, and 2005-8. In both periods the UK was experiencing inflation above the Bank of England (BoE) target of 2%. This suggests that investors are willing to accept a lower spread between real estate yields and government bonds in periods of high inflation due to the perception that real estate is an inflationary hedge.

The Spread: What other factors impact capital values?

The volatility in the real estate-bond yield spread suggests the complex influence of several factors playing a role in affecting real estate yields. These include capital markets, macroeconomic variables, and real estate fundamentals.

The spread is related to the expectations around rental and capital value growth, which in turn are related to the supply/demand dynamics of a particular market. If demand for real estate from investors and/or occupiers is high relative to supply, then there will be a downward yield pressure. Where supply is high, for example due to a wave of development completions or occupier bankruptcies, this would exert upward yield pressure.

Despite the disruption brought on by the pandemic, many markets in both the office and logistics sector are undersupplied with available space. Figure 4 shows how the vacancy rates across European office and logistics and industrial properties are significantly below the levels witnessed in the aftermath of the GFC.

European-office-and-logistics

A combination of rising construction costs and economic uncertainty has also impacted the development pipeline for both the office and logistics sector. The lack of new stock being brought to the market will exacerbate the current supply/demand dynamics and cause faster prime rental growth.

Debt financing availability has also risen over the last decade due to greater availability of non-bank lenders. This will help maintain yields more than has been done in the past when interest rates rise.

Companies are also in a much healthier position today than they were during the GFC. Figure 5 shows the average loan to value ratio across Europe which has declined from a high of 58% in 2009 to 35% at the end of Q2 2022. As such companies should be better able to protect the downside during a weaker economic environment and, crucially for real estate investors, continue to pay their rent.

Loan-to-value-ratio

The weight of capital targeting real estate across Europe has doubled over the last ten years due to both greater desire for real estate exposure amongst historic investors and new entrants to the market such as sovereign wealth funds.

The significant weight of capital was reflected in the investment volume during the first half of 2022 which totalled €143bn according to RCA. This was the largest transaction volume recorded in H1, and also makes Q2 2022 the second highest rolling 12-month period on record, reflecting investors strong desire to put their money into real estate.

Conclusion: Interest rates are important but not the only factor

The combination of positive rental growth expectations brought on by encouraging supply/demand dynamics, the versatility in the debt markets, and sheer amount of money allocated towards real estate suggests that the spread between 10-year government bonds and real estate yields will be lower in the future. This would therefore reduce the rate of yield softening brought on by rising interest rates. Although we have used data on the European real estate market to explore this topic, the same trends permeate all western markets, and the implications are likely to be the same.

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July 12, 2022

The relationship between interest rates and real estate yields

The relationship between interest rates, real estate yields and performance is important for investors to understand.

Cromwell’s latest report published by Alex Dunn and Tom Duncan from the research and investment strategy team sheds some light on this topic. Their analysis indicates that interest rate movements do not necessarily cause directly comparable real estate yield changes. The volatility in the yield gap between real estate yields and ten-year government bonds suggests that the influence of other factors play a substantial role in price movement.

This has implications for the extent of yield compression that investors can expect during periods of falling interest rates, as well as decompression when interest rates rise.

The full report can be found by clicking here.

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May 22, 2022

Supply chain adaptation will boost European occupier demand

A retreat from global supply chains is underway as businesses seek to maintain greater local inventories and production capacity. As global logistics networks are strained, businesses cannot yet fully enact their re-organisational plans despite a strong desire to do so. This implies momentum has yet to build and will only accelerate. More local inventory and production means more physical space required. With logistics and industrial/light industrial floorspace supply already at record lows across Europe, intensifying occupier demand will create even stronger rental impetus.

 

From global to local: how supply chains are changing

One of the most immediate and lasting impacts of the COVID-19 pandemic has been supply chain disruption. Erratic swings in demand – toilet rolls and computer monitors one minute, bicycles the next – were exacerbated by logistics interruptions ranging from congested ports and the Suez Canal blockage, labour shortages across the transportation industry and bans on certain exports deemed to be of national importance.

The extent of the disruption reflects the international nature of supply chains which first emerged in the 1980s enabled by new technology and globalisation.

A ‘Just-In-Time’ (JIT) supply chain philosophy in which decisions on where to source, manufacture and store stock are made purely on a financial basis has become standard practice. Goods and components are shipped on demand just before they are needed to minimise storage costs and optimise working capital. Production facilities are located in emerging economies with lower labour and operational costs.

The downside of JIT networks is that they rely on stability and do not cope well with sudden, unexpected change. Rapid demand fluctuations, shipping backlogs or border issues erode their functionality and undermine the ability of businesses to fulfil orders. Reliably mitigating disruption means prioritising resilience over cost, with higher volumes of inventory being stored and production being undertaken locally where it can be better guaranteed. This is the ‘Just-In-Case’ (JIC) approach, the benefits of which have been viscerally demonstrated by the pandemic and, as a result, a mass pivot towards it is underway.

A global survey of senior supply-chain executives by McKinsey, a management consultancy, in Q2 2020 found that 93% planned to make physical changes to their supply chains to ingrain flexibility, agility and resilience in response to the pandemic1. Multiple initiatives were planned including diversification of raw material sourcing, increasing critical inventory and nearshoring production and suppliers.

A survey of global CEOs by KPMG, a professional services firm, in Q3 2021 established that ‘supply chain risk’ was jointly ranked as the top threat to business growth alongside cyber security and climate change risk2. It was ranked second in 2020 reflecting the growing awareness of, and concern with, supply chain risk. There was a marked 10 percentage point increase in CEOs rating this as the biggest threat. Supply chain adaptation is clearly at the forefront of corporate agendas.

Rising risk and uncertainty: why change is occurring

Multiple factors are combining to foster rapid supply chain adaptation. The pandemic brought urgency to the need for change, ensuring that all businesses understand how fragile supply chains are and the need to ingrain resilience. Supply chain pressure rose immediately, reaching record levels in the Eurozone and the UK in June 2020 (figure 1). Pressure remains significant with global supply chain pressure peaking in December 2021. This reduces business output, erodes profitability and adds to inflation.

As with other structural changes though, the pandemic merely accelerated a pre-existing trend rather than creating it. Supply chains were becoming more localised and manufacturing activity was already nearshoring but the pace was much slower. The ability for supply chains to adapt is being fuelled by a variety of drivers (figure 2).

Ultimately the negative externalities of complex, lengthy supply chains and consolidated production have risen as uncertainty prevails and risk escalates. In parallel, the feasibility of nearshoring production and localism supply chains has increased. The cost/resilience balance is swinging in favour of the latter.

The trend towards JIC is only starting to gather momentum. Because supply chains remain heavily disrupted and are likely to remain so for some time, it is difficult for companies to satisfy existing demand, build inventory and relocate production concurrently.

It takes time to recalibrate supply chains which have developed over decades. It takes even longer to relocate production facilities and increase output sufficiently to replace offshored factories. However, it is far quicker to store greater inventory than relocate factories.

The McKinsey survey was undertaken twice in Q2 2020 and Q2 2021. Analysis of the results clearly shows that whilst many companies planned to nearshore activity in Q2 2020, few had done so a year later. By contrast, far more companies had increased their inventories by Q2 2021 than the number of those that had anticipated doing so in Q2 2020 (figure 3).

Despite businesses increasing inventory, stock remains extremely depleted. Evidence from Capital Economics, a data provider, indicates that companies deem Eurozone manufacturing stock levels to be ‘too small’ by the largest margin in at least two decades after a sharp falling during the pandemic (figure 4).

A Q4 2021 global survey of 125 senior level executives in the life sciences, machinery/automotive and consumer durable goods sectors by BCI Global, a supply chain consultancy, found that 85% rated “shortage of components/commodities/raw materials” as the biggest supply chain challenge today3. Delivery times remain lengthy which prevents companies from building sufficient inventory (figure 5). It will be some time before these times shorten given the extent of the backlog.

Meaningful scale-up of nearshored production capacity is unlikely to be achievable until the medium term. Significant planning is involved, given the dramatic reorientation of process and supply chains that this involves as well as the high capital investment. That is why there has been little evidence of nearshoring production to date despite business indicating that they plan to do so.

Nearly 90% of McKinsey respondents stated that that they expect to pursue some degree of regionalisation during the next three years. This is corroborated by the BCI Global Survey which established that 60% of respondents plan to nearshore activity away from Asia within the next three years.

The implication of this analysis on the extent of supply chain adaptation and manufacturing nearshoring is that this recalibration is at a very early stage. It is only just starting to gather speed and it is a trend with longevity.

Significant floorspace demand: occupier demand will escalate

Greater inventory and nearshored production require physical floorspace. Occupier demand for logistics, warehousing and industrial/light industrial stock will rise, compounding the existing supply/demand imbalance in favour of landlords.

In terms of specification, storage space requires little other than volume. This may mean that demand is focused on more affordable secondary logistics and warehousing space with height. The need for physical proximity to customers and producers implies that all European countries are likely to absorb rising demand and that transport connectivity will be a locational driver. Space near major transport nodes such as seaports, airports and multi-modal terminals may be most desirable.

Although modern production processes have lower labour requirements, labour is still needed. This suggests that Central and Eastern European (CEE) countries where labour is cheaper and more readily available along with lower operational costs may be most attractive. Western European markets are still easily accessible from the CEE. The BCI Global survey established that respondents considered CEE countries to be the most sought-after European countries for nearshored production. That said, the primacy of resilience over cost means that demand is directed towards western European countries too. Demand is expected to be focussed largely on industrial/light industrial space.

Production facilities typically rely on support from suppliers and logistics subcontractors. As such, the emergence of new nearshored production facilities will stimulate broader occupier demand in their surrounding localities. They are demand catalysts.

A rising tide lifts all boats: stronger rental growth is the most likely outcome

Analysis from a range of data sources and forward-looking business survey indicators suggest that Europe is on the cusp of experiencing a sustained build-up of inventory storage and a transition towards nearshored production. This will lead to substantial and prolonged demand for additional logistics, warehousing and industrial/light industrial space.

A rising tide lifts all boats. Even if demand is concentrated on storage and focused on secondary stock and production demand on light industrial/industrial, it will still limit choice and reduce optionality for occupiers across all types of logistics and light industrial space. This is likely to intensify competition for space, exacerbate the existing supply shortfall and stronger, more protracted rental growth.

Footnotes

1 McKinsey, 23 November 2021, How COVID-19 is reshaping supply chains
2 KPM, 1 September 2021, 2021 CEO Outlook
3 BCI Global, 16 February 2022, Global Reshoring & Footprint Strategy

DISCLAIMER
This material is prepared for discussion only and should not be relied upon for any other purposes. It has been prepared on a good faith basis but its contents have not been formally verified and no Cromwell entity or person accepts any duty of care to any person in relation to the information it contains. It should not be considered to be investment advice, marketing material or a promotion or offer of any Cromwell fund, product or services. Any person that wishes to invest in any Cromwell fund, product or services should refer to the relevant information or legal documents produced in relation to such opportunity before making any investment or other decisions. This document reflects the views of its author as at 9 May 2022.

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April 7, 2022

Timber buildings – Truly sustainable real estate

In this special report, our Research and Investment Strategy team explore how timber buildings can be a critical part of the solution the real estate industry needs to mitigate climate change.

The report takes a deep dive into timber as a renewable building resource. Alex Dunn and Tom Duncan explore how using timber in new building construction can deliver positive environmental impacts and lead to truly sustainable real estate. They provide a balanced view of the benefits and challenges of timber construction; address some common misconceptions around its use and consider the advantages from an occupier and investor perspective. This is essential reading for all real estate stakeholders who are serious about enacting impactful environmental change.

The full report can be found by clicking here.

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March 8, 2022

ESG: a duty, not an option

The topic of environmental, social and governance (ESG) matters has been brought into sharp focus in recent times, thanks to the lessons of the pandemic, new EU regulations, and alarming emerging metrics on emissions and the impact of the built environment’s carbon footprint.

Sandrine Fauconnet, European ESG Manager recently participated in PropertyEU’s ESG roundtable where she and a panel of experts agreed that although the real estate industry has now grasped the importance of ESG, considerable action is still needed to make a difference.

The full roundtable discussion can be found by clicking here.

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March 8, 2022

Welcoming all talents

The global health crisis has been a stark reminder that companies need talented professionals to help them survive and thrive when unforeseen ‘black swan’ events disrupt business.

As the pandemic moves from a crisis phase into a management phase across Europe with the relaxation of restrictions, forward-thinking real estate firms are prioritising diversity and inclusion (D&I) to ‘crisis-proof’ their operations and boost performance.

Cromwell’s European Head of Capital Solutions, Danya Pollard , ESG Manager, Sandrine Fauconnet and Fund Manager, Eeva Saravuo recently spoke to PropertyEU about the importance of D&I in the real estate industry and the concrete steps Cromwell is undertaking to enable real change.

The interview can be found by clicking here.

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March 8, 2022

German logistics – Diversify for performance

Michael Bohde, Head of Germany, Cromwell Property Group

German logistics is hot. Occupational activity has been record-breaking as rising ecommerce penetration and the shift towards supply chain resiliency has supported demand. According to our calculations an additional two million sqm of logistics space alone will be needed in Germany over the next five years to accommodate ongoing growth. Given land supply is highly constrained, this bodes well for future rental growth prospects.

Reflecting this, investors are acquisitive. Last year some €28bn was sunk into European logistics according to RCA. German logistics/ light industrial transaction volumes in 2021 equated to €9.2bn according to Colliers or €10bn according to CBRE. With so much capital chasing such limited stock, yields are under pressure. Over the last year prime logistics yields have compressed by 40 basis points to reach 3.0% in Q4 2021 according to CBRE, and if their forecasts prove correct further moderate sharpening is likely.

/Logistics-warehouse

This leaves many investors pondering how they can benefit from the sectors growth prospects without compromising on well-priced entry yields. In our view, informed investors have two routes in particular to secure more value: increase the light industrial allocations or gain pan-European diversification.

Light industrial shift

Light industrial stock comprises space used for manufacturing, production activities such as part assembly and repackaging or research and development. Typically light industrial has higher office content than logistics stock and may comprise smaller assets or multi-let tenancies. Like logistics it benefits from exposure to cyclical economic and structural growth in online retail and supply chain recalibration but at more compelling entry prices.

Light industrial accounts for a large proportion of German industrial and logistics supply. Much of this is situated in urban areas where land competition is intensifying due to urbanisation. This underpins land value and offers future upside potential from densification for either co-located light industrial/logistics with other mixed-uses, or potential conversion to other uses entirely such as residential. This has the potential to deliver better performance.

Unlike logistics though, light industrial stock is far more differentiated and bespoke to the occupier and purpose. To acquire stock with resilient income and growth potential, investors must apply a granular approach to stock selection. Although granularity is needed, the right specialist can still build scale quickly, comparable to a logistics portfolio. Partnering with investment managers who understand local markets, are well connected to occupiers and can make informed decisions is vital.

 

Logistics Pan-European diversification

Another option for distribution-seeking investors is to expand into other higher-yielding European markets. Prime logistics yields of 4.25% in the Czech Republic, 4.35% in Poland and 3.95% in Italy are clearly appealing relative to Germany (figure 1). Occupier demand for quality stock in these markets is rising and land supply in the top locations is tight.

Not only will pan-European diversification bolster distributions, but it also spreads income risk by gaining exposure to assets and occupiers subject to different country dynamics. This reflects both the unique economic prospects of each European country and, of particular relevance to logistics performance, differing stages of online retail market maturity.

Countries with ecommerce penetration of below 10% of total retail spending are immature. Analysis from mature markets such as the UK and Netherlands demonstrates when penetration rises above 10%, logistics occupier demand also accelerates. The demand impetus typically proceeds faster than the supply response, especially given it is increasingly hard to find sites and gain permission for new logistics development, leading to rapidly escalating rents. Rental growth tends to endure when markets reach maturity above 18% penetration as occupiers seek to consolidate their distribution networks to maintain market share.

European-country-level-ecommerce

Many European countries have recently entered the maturing stage of ecommerce growth (figure 2). In addition to Germany (16% online penetration in 2022 according to CBRE) these include the large Italian (10%) and Central and Eastern Europe economies (14% and 17% in Poland and Czech Republic respectively). This bodes well for future rental growth prospects in these countries and those who invest there.

European-ecommerce-market

Wise pan-European diversification requires a robust understanding of local market dynamics. Whilst logistics stock is fairly generic, local country particularities have a significant impact on return prospects and requires granular market expertise in order to make informed decisions.

Broader allocation will deliver income

In summary, we expect that compelling long-term fundamentals in the logistics sector coupled with low distribution yields in core logistics will prompt a growing number of investors to diversify. Diversification will encompass acquiring higher-yielding light industrial stock in Germany which benefits from exposure to similar occupational drivers and often has underlying land value. It will include European diversification to gain exposure to stock likely to benefit from rapidly escalating occupier demand at more compelling yields. Such diversification also spreads risk and smooths income returns.

Effectively executing a diversification strategy of this nature requires partnering with an informed investment manager with a true pan-European presence. This is a sophisticated approach which relies upon detailed knowledge of evolving occupier demand and how that relates to real estate. Local markets must be thoroughly understood in order to understand their unique characteristics and identify the most attractive investment opportunities. Local relationships with landlords and occupiers will also help to maximise performance potential.

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February 9, 2022

Retail revival – Uncovering value in a changing landscape

In Cromwell’s latest briefing note, Tom Duncan and Alex Dunn from the research and investment strategy team discuss the outlook for the retail sector. Whilst it has faced challenging short-term conditions, the prospects for physical retail that has a role in an e-commerce-infused world are bright. They discuss the investment strategy implications of this and the opportunities to uncover immediate and long-term value.

The briefing note can be found by clicking here.

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