The chart shows the rental development in the 70 largest markets monitored by Prologis Research. The rents are weighted averages based on estimates of market income © Prologis Research

The reduction of risk in the global value chain is driving structural demand: Properties that are close to the end user and have access to high-quality infrastructure were in the highest demand and are likely to continue to perform better.

The construction cost basket shows the enormous increase in construction costs for logistics real estate in Europe and the USA, based on construction prices in 2010. © Prologis Research

Meanwhile, the volume of buildings under construction increased as developers turned to alternative locations with fewer restrictions to meet demand. To illustrate, despite rising demand for space and rental growth in urban locations, the proportion of total European development in urban markets fell from 28 percent to 19 percent from 2017 to 2022. As a result, companies need to make quick decisions in order to secure urgently needed space in prime locations, for which a structural undersupply is also expected in the future.

Construction costs drive up rents

Construction costs rose as materials became scarce and supply chains were disrupted by Covid-19, the war in Ukraine, labor market turmoil and rapid inflation. As a result, material costs increased by 39% in the US and Canada over 24 months (from October 2020 to 2022) and by 35% in Europe. Rising construction costs combined with land being purchased at peak prices prompted developers to increase rents to support new developments.

Rising replacement costs underpinned rental growth in all markets, but the impact was strongest in land-rich locations where new supply can rise quickly to meet demand and where developers are building on low margins, such as in Poland. Pressure on the supply chain is gradually easing, as evidenced by material costs stabilizing in some markets and falling in others. The expected decline in material costs and land prices in 2023 will be offset by an expansion in yields, which will require higher rents to justify the risk of development.

Rental growth will normalize

Location is crucial, as transportation costs fluctuate widely and consumers' expectations of service levels remain high. Therefore, markets with high-quality infrastructure close to the end consumer are likely to outperform others. After record rental growth of 30 percent in 20221, Prologis Research expects rental growth to normalize due to a slower pace of business due to slowing economic growth and decreasing urgency.

Converted into real purchasing power, effective market prices in Europe today are no higher than they were 15 years ago. © Prologis Research

Structural forces, including the growth of e-commerce and the reshaping of supply chains, are likely to drive expansion over the cycle. However, regulatory barriers, land scarcity and rising capital costs will continue to limit new supply and rental conditions are unlikely to ease in the hardest hit markets.

Regional developments in the USA and Canada

Year-on-year rental growth in the USA/Canada accelerated to an all-time high of 34%. With record low vacancy rates in most locations and widespread demand, rental growth was strong in many markets. The vacancy rate was in the low 3% range in 2022. Prologis clients reported both strong activity and high occupancy rates during the year. The IBI, Prologis' proprietary customer sentiment survey, showed healthy activity of 60 percent and a high occupancy rate of 86 percent at year-end, indicating minimal remaining space and a continued need for warehouse space for future growth.

The pace of decision-making is normalizing and is unlikely to accelerate again next year given the growing economic uncertainty. At the same time, occupiers will have more options due to Prologis' record pipeline of approximately 50.6 million square meters across its 31 markets. Against this backdrop, rental growth is likely to slow from its recent high pace, but should remain well above inflation.

Very low vacancy rate causes rents to rise in Europe

Rents rose at a record pace in Europe in 2022, increasing by 15% compared to the previous year. Vacancy at the end of 2022 was near record lows at 2.7 percent, leading to an acceleration in rents across all markets. Prologis sees a clear relationship between actual monthly supply and supply risk and rental growth, as the growth trajectory was steepest in the locations with the lowest vacancy and highest supply barriers.

Significant increases in replacement costs (accelerated by the war in Ukraine) drove up rents, even in locations with a higher supply of space. In Poland, for example, rents rose by more than 20 percent, a market that has lagged behind in the past. The trend slowed in 2022 and lower completions are expected to be accompanied by weaker demand in 2023, allowing only a moderate increase in vacancies. An economic slowdown could further worsen market conditions, although vacancy rates are exceptionally low and are expected to rise only moderately, offsetting the negative cyclical impact on rental growth. In fact, rents increased in the fourth quarter of 2022 (3%), even as the macroeconomic situation became more uncertain.

Low rental growth in China

Rental growth in China slowed throughout 2022, ending with year-on-year growth of 0.2 percent, a slowdown from historical growth of around 4-5 percent per year. While completions remained close to the record high of around 9.5 million square meters, strict Covid-19 restrictions that began in the second quarter curtailed demand, causing the national vacancy rate to rise to 19 percent from 16 percent at the end of 2021.

Rental growth was higher in urban clusters with a shortage of land, and customers competed for the limited space available. In urban agglomerations, where the vacancy rate at the end of the year was around 10 percent, rents rose by 1.6 percent, while a decline of 2.5 percent was recorded in non-agglomerated metropolitan areas with a vacancy rate of more than 20 percent.

This article appeared in issue 3/23