Global Industrial Real Estate: Current Trends and Potential Disruptors

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Randall Hicks
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PUBLIC SECURITIES GROUP i 2018 REAL ESTATE Global Industrial Real Estate: Current Trends and Potential Disruptors There are currently several opposing forces at work within the industrial real estate

1 PUBLIC SECURITIES GROUP i 2018 REAL ESTATE Global Industrial Real Estate: Current Trends and Potential Disruptors There are currently several opposing forces at work within the industrial real estate sector. Demand drivers like e-commerce and supply chain modernization remain very strong. At the same time, however, new completions and elevated company valuations require consideration. There are also a number of potential disruptors that could change how industrial developers and landlords operate. 1

2 Global Industrial Real Estate: Current Trends and Potential Disruptors Strong Backdrop Industrial real estate has been among the strongest performing property types in recent years. Positive demand from e-commerce growth has resulted in low vacancy rates and low cap rates, translating into strong returns for investors. In both public and private markets, U.S. industrial real estate posted the highest sector-level returns over the past one-, three- and five-year periods through December 31, ANNUALIZED RETURNS OF PRIVATE AND PUBLIC INDUSTRIAL REAL ESTATE PERIOD ENDED DECEMBER 31, 2017 NCREIF PROPERTY INDEX (NPI) INDUSTRIAL FTSE EPRA/NAREIT NORTH AMERICAN INDUSTRIAL INDEX One-year 13.1% 23.3% Three-year Five-year 13.4% 13.2% 18.1% 16.4% Source: Bloomberg, National Council of Real Estate Investment Fiduciaries. See index definitions in the disclosures section at the end of this document. Positive performance has resulted in what we believe are elevated valuations for the public sector relative to the broader real estate universe. The spread between the average funds-from-operations (FFO) multiple for industrial stocks compared to that of the broader universe is wider than it has been in the past seven years. Healthy growth in e-commerce sales has been a key driver for demand growth for industrial real estate. Total U.S. e-commerce sales increased 16% in 2017, to $453.5 billion. We believe that double-digit growth rates will continue globally for e-commerce. This strong demand backdrop over the last few years has been met with limited new development deliveries, resulting in record low vacancies and strong rent growth for industrial landlords in North America. INDUSTRIAL PROPERTY VALUES AND CAP RATES Mar-00 Mar-01 Mar % 9.4% Mar-03 Mar-04 Mar-05 Mar-06 Mar % Mar-08 Mar Mar-10 10% 5.3% 6% Source: Green Street Advisors, November See index definitions in the disclosures section at the end of this document. Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Commercial Property Price Index (Indexed to 100 in July '07) Industrial Nominal Cap Rates (%) 131 Mar-17 9% 8% 7% 5% HISTORICAL VALUATION: BROAD REAL ESTATE VS. INDUSTRIAL SECTOR 25x 20x 15x 10x 5x 0x Current Spread: 5.6x Average Spread: 1.9x Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q North American REIT Weighted Average FFO Multiple Industrial Sector Weighted Average FFO Multiple Source: SNL, January See index definitions in the disclosures section at the end of this document. GLOBAL INDUSTRIAL REAL ESTATE: CURRENT TRENDS AND POTENTIAL DISRUPTORS 2

3 Potential Challenges Ahead Going forward, however, we think demand is likely to normalize and vacancy rates will move higher as completions increase. Additionally, certain U.S. coastal infill markets have seen rent pressure as existing supply is repurposed for other uses. This has led to strong industrial rental rate increases in recent years, but going forward, we expect that growth to slow. Over time, we think the industry will see decreases on mark-to-market rent renewals on U.S. portfolios and investment returns are likely to moderate. INDUSTRIAL REAL ESTATE MARKET % Forecasted 14.0% % 12.0% Million SF (MSF) 50 0 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q % 10.0% 9.0% 8.0% % 6.0% -100 Quarterly Absorption (MSF) Quarterly Completions (MSF) Vacancy Rate (%) 5.0% Source: CBRE Econometric Advisors Despite the overall trends in e-commerce growth, changes in strategies among industrial tenants could moderate demand. As retailer e-commerce platforms mature, capital expenditures related to technology, fulfillment and distribution have been declining. This ultimately translates into slowing demand growth. Additionally, retailers are facing pressures related to shipping costs (both deliveries and returns), which have been driven higher primarily by a shortage of labor. These costs make up more than 50% of retailers cost structures and are growing. We see a move toward a buy online/pick up in store model. More online shoppers are embracing this option, citing speed as the top reason. Retailers prefer the option as it reduces expenses related to fulfillment centers and shipping costs. This is particularly important in the grocery space where competition is heating up in the online channel following the acquisition of Whole Foods by Amazon. Other examples include: Target s acquisition of Shipt, making same-day delivery an option at about half of its stores in early 2018 Wal-Mart s plans to double the number of in-store pickup locations Zara s use of robots to fulfill in-store pickups, which account for one-third of the company s global online sales Although retailers are experiencing double-digit sales growth in e-commerce channels, rising cost pressures associated with these growing digital platforms are forcing these companies to optimize distribution channels. Ultimately this could result in slowing demand and deceleration of rent growth in the industrial real estate market. GLOBAL INDUSTRIAL REAL ESTATE: CURRENT TRENDS AND POTENTIAL DISRUPTORS 3

INDUSTRIAL PROPERTY VALUES AND YIELDS International Spotlight U.K. and Japan Outside the U.S. market, we think a number of current trends are worth watching.

Property values have meaningfully risen over the last few years as net initial yields (cap rates) have declined. The underlying fundamentals in the U.K. continue to be strong.

The supply chain was typically fragmented with multiple layers, but modernization has resulted in consolidation.

4 INDUSTRIAL PROPERTY VALUES AND YIELDS International Spotlight U.K. and Japan Outside the U.S. market, we think a number of current trends are worth watching. Despite uncertainty related to Brexit trade negotiations in the U.K., the region s industrial real estate sector has been resilient. Property values have meaningfully risen over the last few years as net initial yields (cap rates) have declined. The underlying fundamentals in the U.K. continue to be strong. Online penetration is higher in the U.K. compared to the U.S., but valuations in public markets appear to reflect this currently. U.K. Industrial Property Prices (Indexed to 100 July 06) U.K. Net Initial Yield (%) Source: Green Street Advisors, November 2017 The Japanese industrial market has undergone a significant transition. The supply chain was typically fragmented with multiple layers, but modernization has resulted in consolidation. The amount of advanced logistics facilities as a percentage of total industrial supply has more than doubled over the past five years (from 1.9% to 3.9%), according to CBRE. These modern logistics facilities are taller buildings with multiple stories, increasing the usable square footage without increasing the footprint. We believe that new deliveries of advanced logistics facilities will outpace demand in 2018 as deliveries are forecasted to be 7.5% of the current existing supply. In general, we believe the first movers in this wave of new supply have received attractive return on capital, but we are cautious going forward as new supply begins to outpace demand. Source: CBRE Research GLOBAL INDUSTRIAL REAL ESTATE: CURRENT TRENDS AND POTENTIAL DISRUPTORS 4

Potential Disruptors We see several potential disruptors on the horizon that are worth considering as we forecast growth rates for industrial real estate.

5 Potential Disruptors We see several potential disruptors on the horizon that are worth considering as we forecast growth rates for industrial real estate. The first is the adoption of autonomous vehicles. The value of industrial real estate could be significantly impacted as autonomous vehicles and commercial vehicle fleets reduce congestion and travel times. We would expect to see a shift in relative values of industrial real estate, likely slowing rent growth in infill markets and driving growth higher in nearby low-rent markets. Source: Brookfield Investment Management Inc. Additionally, driverless fleets will help alleviate pressures in the trucking industry, which has struggled to keep pace with demand amid a shortage of drivers. We believe this may result in additional shadow supply of industrial product in the form of more trucks on the road transporting goods. On the positive side for industrial real estate, autonomous vehicles will dramatically reduce the cost structure for shippers, as half of these expenses are related to wages and benefits. This could make online shopping and delivery a more cost competitive option to in-store retailing. The second disruptor is Amazon s rethinking of the supply chain. The company recently launched a trial program in an effort to shrink inventories and shorten delivery times (and therefore reduce costs). In the company s current Fulfillment by Amazon process, goods are shipped from merchants to Amazon warehouses. Amazon is then compensated for storing, packing and delivering items once they are ordered by customers. Under its trial program, Amazon is making its shipping and logistics software available to third-party vendors; and will manage the pick up and delivery of merchants goods from third-party warehouses. This essentially allows Amazon to ship to consumers directly from third-party facilities, eliminating the need for an Amazon sorting facility and therefore reducing its logistical footprint. Investment Implications While the fundamental, long-term demand drivers for the sector remain positive, we currently have a cautious view on the industrial sector in the public markets. We see some challenges that are more near term and concrete, while others are longer term and more abstract. We are considering all these risk factors as we seek to identify companies in the sector with the best growth prospects at the best valuations. GLOBAL INDUSTRIAL REAL ESTATE: CURRENT TRENDS AND POTENTIAL DISRUPTORS 5

6 DISCLOSURES As of March 29, Brookfield Investment Management Inc. Brookfield Investment Management Inc. ( Brookfield ) is an SEC-registered investment adviser and represents the Public Securities platform of Brookfield Asset Management Inc. ( BAM ), providing global listed real assets strategies including real estate equities, infrastructure equities, multi-strategy real asset solutions and real asset debt. BIM is a wholly owned subsidiary of BAM. The information in this report is not and is not intended as investment advice or prediction of investment performance. This information is deemed to be from reliable sources; however, Brookfield does not warrant its completeness or accuracy. Brookfield disclaims any duty or obligation to update any information provided in this report. This report is not intended to and does not constitute an offer or solicitation to sell or a solicitation of an offer to buy any security, product or service (nor shall any security, product or service be offered or sold) in any jurisdiction in which Brookfield is not licensed to conduct business, and/or an offer, solicitation, purchase or sale would be unavailable or unlawful. Past performance is not indicative of future results. Performance shown in USD unless otherwise noted. Opinions, if any, expressed herein are current opinions of Brookfield Investment Management Inc. and are subject to change without notice. The mention of specific securities, if any, is not a recommendation or solicitation for any person to buy, sell or hold any particular security. Any outlooks or forecasts presented herein are as of the date appearing on this report only and are also subject to change without notice. Information herein contains, includes or is based upon forward-looking statements within the meaning of the federal securities laws, specifically Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include all statements, other than statements of historical fact, that address future activities, events, or developments, including without limitation, business or investment strategy or measures to implement strategy, competitive strengths, goals, expansion and growth of our business, plans, prospects and references to our future success. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Words such as anticipate, estimate, expect, project, intend, plan, believe, and other similar words are intended to identify these forward-looking statements. Forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many such factors will be important in determining our actual future results or outcomes. Consequently, no forward-looking statement can be guaranteed. Our actual results or outcomes may vary materially. Given these uncertainties, you should not place undue reliance on these forward-looking statements. The quoted indexes within this report do not reflect deductions for fees, expenses or taxes. These indexes are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There may be material factors relevant to any such comparison such as differences in the volatility, and regulatory and legal restrictions between the indexes shown and the strategy. For Institutional Use Only and may not be reproduced, shown, quoted to, or used with members of the public. DEFINITIONS The NCREIF Property Index (NPI) is a quarterly, unleveraged composite total return index for private commercial real estate properties held for investment purposes only. The capital value component of return is predominately the product of property appraisals. The FTSE EPRA/NAREIT North America Index is designed to track the performance of listed real estate companies and REITs in North American markets. Green Street s Commercial Property Price Index is a time series of unleveraged U.S. commercial property values that captures the prices at which commercial real estate transactions are currently being negotiated and contracted. Nominal cap rates calculated as the difference between revenues and operating expenses, as a percentage of property value. An FFO multiple is the multiple of funds from operations (FFO) per share of a company. FFO measures net income, excluding gains or losses from sales of property and adding back real estate depreciation. Infill industrial developments are typically situated in established markets, where new supply cannot be easily added due to geographical or other constraints. ENDNOTES i. The Public Securities Group (Brookfield Investment Management Inc.) is a wholly owned subsidiary of Brookfield Asset Management Inc. CONTACT US Telephone: publicsecurities.enquiries@brookfield.com Or visit our website at Brookfield Investment Management Inc. RE_03-18 GLOBAL INDUSTRIAL REAL ESTATE: CURRENT TRENDS AND POTENTIAL DISRUPTORS 6

Fixed Income The ICE BofAML Global High Yield Index declined 1.0% and the ICE BofAML Global Corporate Index declined 0.4%.

Fixed Income The ICE BofAML Global High Yield Index declined 1.0% and the ICE BofAML Global Corporate Index declined 0.4%. November 2018 Commentary Diversified Real Assets Securities Strategy MARKET REVIEW Global equities rebounded in November following the previous month s selloff. The MSCI World Index advanced 1.2%, with