Towards a sustainable logistics real estate market
At the crossroads
Why do people always have to do things the hard way? Is it that we like a challenge, or are we simply focused on short-term benefits? The world offers a number of freely available energy sources that represent so much power that the world’s population could double in size. Nevertheless, humanity has chosen to use energy sources that need to be extracted from deep inside the Earth, and then they have to be processed before they can be used to provide energy. Throughout history, the development of energy sources has been a hit-and-miss process. Mineral oil for example used to be sold cheaply as a lighting product for decades before it finally became the world’s premier source of energy.
We still really have no idea about the sources of energy that still exist, let alone which of them will become important in the future. A great example of how the direction of human innovation can change can be found in the development of the internal combustion engine and the growth of commercial aviation. Together they brought us growth, but they also brought problems and uncertainty. We now see that the problems with our energy supply are reaching the point where we need to find solutions by creating a new path to new energy sources. Better still, we should try to use less energy to sustain our way of life. We should live greener.
The Global Crisis
The logistics real estate market is currently experiencing hard times as a result of the global crisis. Some years ago the financial markets felt that this market was a safe place for pension funds, so they decided to enter this niche market. This decision worked out very well for the users as rent levels stabilised. Also, developers could realise higher profits due to yield compression following the higher demand for new investments. The feeling of the financial market was confirmed by this positive trend, and more money was targeted at these activities. However, the market overheated almost immediately due to the large volumes of new money and the lack of experience of the newcomers. Their investment strategy involved a very basic real estate principle, that investing in a good location is always profitable. This may be a very stable indicator for investing in real estate, but for the logistics real estate market it is an unstable factor.
Of course, it is important to have a location which can accommodate tri-modal solutions for customers , and a good infrastructure is also essential, but the supply chain world is changing so rapidly that within the course of a year, what was once a commercial hotspot can be come a seco
ound traffic may still be favourable as the hotspot location is based on the inbound traffic facilities, but the cost of transport to the customer will rise and it will become impossible to achieve the optimum supply chain network.
Large supply chain networks are supposed to be designed to be flexible to change with the trend, and central distribution centres and regional distribution centres are located as close as possible to the centre of activity. Even so, they may still encounter problems due to geographical differences in the customer base, if the activity study is based on incorrect forecasts. With the financial crisis it has become clear that the forecast models are no longer sufficient to handle such large shifts in spending patterns, and so we need to look at new strategies to handle these problems.
Normally an organisation can improve its flexibility by changing its supply chain strategy and trying to increase its buffer, but in the end it appears to be a problem of the whole industry. We are currently having to deal with initiatives to improve sustainability and with very fast-changing consumer spending patterns. So how should we go about creating a sustainable network for the future?
Companies with a network that includes the entire European customer base will use their forecasting models to analyse the inbound and outbound traffic in order to find suitable locations for their distribution model. These analyses are based on the combination of inbound and outbound volumes and the working capital within the supply chain. The strategies for these three main elements are all very different and it is therefore not easy to incorporate them into a single overall strategy.
However, the growth of the past ten years has caused this diversity to be overlooked, so many companies have chosen an overall growth strategy for their real estate. This strategy was also followed by the investors and developers of logistics real estate. They started to buy empty warehouses and developed a lot of warehouses on speculation in central locations throughout Europe. Their idea was that this new offering of warehouses would be easily filled within a single year, with contracts lasting at least five years. Lately we are seeing a lot of empty warehouses in the logistics hotspots due to the failing economy. Have these hotspots outlived themselves?
To find an answer to this question we need to look at the three main factors that decide what strategy to adopt for locations within a network.
Inbound transportation is a very stable factor in the supply chain, because the number of stock-keeping units per shipment tends to be less than for outbound shipments, and because they can be easily managed through direct shipments from the supplier to the location. The biggest challenge lies in keeping the iron inventory at the right level, in finding the most efficient transport to minimise costs, and in having a better green strategy for the supply chain.
It is therefore very useful if river barges or a very good road infrastructure can be used to get from suppliers to the location. If we look at the European top ten hotspot locations, they all offer these features. In other place too, municipalities have decided to invest substantially in such infrastructures to attract new logistics operations to their region. This trend will enable businesses to weigh the pros and cons of more locations in Europe. The inbound traffic objectives can be achieved by creating a Central Distribution Centre (CDC).
The biggest challenge for every supply chain anywhere in the world is its outbound traffic. Everything depends on the geographical customer base, the number of stock-keeping units, and the customer’s spending pattern. Companies spend a lot of money to monitor and forecast these factors as they not only affect supply chain decisions, but also determine the day-to-day running of the company. The global crisis has made the network design of these outbound distribution models very fragile, and it is very hard for companies to rely on these models and look three years ahead.
At this moment it is also very difficult to predict what kind of impact green thinking on the part of the customers will have on their behaviour. Will they be looking for new markets, or will the customers merely focus on a product’s carbon footprint? This will have a major impact on the future supply chain, but how do we make the right decision at this point in time? Flexibility is needed when designing an outbound strategy if it is to cope with rapidly changing demands.
Companies with very competitive customer service models will need to use Regional Distribution Centres (RDC) to serve local markets. The total inbound transport cost will have to be reduced by combining transport between the CDC and the RDCs. Any market changes will first be felt at these RDC locations, since they are closest to the market.
A quick way of achieving the required flexibility is to shorten the lease of the RDCs. This ensures more flexibility in the future. The terms of the contract will also have to be more flexible. If a company leases 20,000 m² for a number of years, it will try to get an option for scaling up or down its operation to suit the need of the moment. Of course, companies owning real estate will not be very eager to offer such an option, since their primary concern is to create a stable cash flow for their investors.
Even so, it could start with large companies using larger CDC-RDC networks. They could look at the total number of square metres leased from a company, and work out a flexible European lease contract. It will give the supply chain flexibility on a national level so costs can be kept in line with demand, while at a European level the highs and lows in demand can more easily be managed. If human resources and the use of internal equipment are factored into this new model for outbound traffic, even more options become available.
When the crisis struck, many companies decided to decrease their working capital in the supply chain. There was an urgent need to generate cash, and an easy way to do so was by lowering inventories at all levels of the supply chain. In doing so, these companies created an opportunity for themselves to get an impression of how the network would function if inventory levels were kept very low. Would it be possible to reduce the warehouse space in the supply chain, or to have more cross-dock centres?
This turned out to be an ideal starting point for a new logistics real estate strategy, as building up the inventory back to the original levels would take longer than the market would be willing to wait for. It is easy to lower the inventory to a level of 25 percent within three months as products near the end of their life cycle. Getting the inventory levels back up to a previous level however, for example that of a year earlier, would take at least nine months, as it would mean restarting production. This resulted in businesses adopting a new strategy, and it is now up the real estate market to adapt to these new times.
Now that we have looked at the three factors, we can conclude that hotspots are not outdated yet. Nevertheless, new times lie ahead, and companies will have to refocus on the new developments in market demand. There have always been two different kinds of hotspots: Central Distribution Centres and Regional Distribution Centres. The main challenge the real estate market faces is to decide what each centre could best be used for. These buildings don’t differ much in value, as the value always depends on supply and demand. The actual difference will be in future lease terms. Will the market give us the opportunity to think in terms of flexible networks, or are we going back to looking at the book value and the cash flow of the property?
The green mile
The present changes in the logistics market are caused not only by the current slump in the economy, but also by the new green principles the world is embracing. Climate protection is one of the most pressing global challenges we are facing today. This is caused by the enormous increase over the past few years in the emission of greenhouse gases, and carbon dioxide (CO₂) in particular. Statistics published by the International Energy Agency (IEA) reveal the major contribution of emissions by logistics processes. In 2005, transport operations were responsible for almost one third of all CO₂ emissions generated by the combustion of fossil fuels in OECD countries.
In recent history good supply chain network design was seen as a very efficient cost-cutting tool. These days it is used to promote the green image of companies. This is a very effective way of reducing emissions from the supply chain. Many companies are starting to invest in sustainable networks. The green way of thinking has been widely adopted, and with the advent of Chief Sustainability Officers it has even managed to penetrate as far as the Board Room. This means that the supply chain of these businesses will change in the near future to become greener than ever before. The whole market is trying to keep the customers satisfied, even though the customers haven’t a clue where they would like their green ideas to take them.
The logistics real estate market has also started to focus on green initiatives. They first tried to make it clear that their buildings could feature all kinds of sustainable solutions, and that this had in fact been established practice for some years. A new trend is to obtain green certification for proposed buildings or for existing building that are being upgraded. Clearly these new initiatives are encouraged by the users of the buildings, as they are always having to pay for the extra green mile in a contract.
There are currently two main environmental assessment systems in use by the European market. The first is BREEAM (Building Research Establishment Environmental Assessment Method), and the other is LEED (Leadership in Energy and Environmental Design). Their main difference lies in the certification process. BREEAM has trained assessors who base their assessment on credit criteria, and report to the local BREEAM institute. This validates the assessment and issues the certificate. LEED does not require any specific training. Instead it uses what is known as an Accredited Professional (AP), whose role is to help gather the evidence and advise the client. The evidence is then submitted to the US-GBC, which conducts the assessment and issues the certificate.
A business may feel confused at the prospect of having to choose between BREEAM and LEED, but there is no need to be. Both systems can happily co-exist and each has its own niche areas and preferred countries. The schemes are even starting to borrow each other’s ideas as they develop. Since we are still in the early stages of new trends, this is a good thing, but large investors will want to know what the effect of these certificates will be on the book value of their products. It appears as if the BREEAM certificate is set to become the preferred method, as it has been adopted by the major logistics countries in Europe. On the other hand it is important to have a global certificate suitable for use throughout the logistics real estate market, otherwise the next five years may not see any changes at all.
This creates a new problem, which is how to revaluate real estate in these new times. Clearly the current devaluations are based on today’s market figures, and refer to market deals that are now being concluded. Will we keep on growing at the same rate, never reaching the old levels for another decade, or will the new market trends determine the value of logistics real estate in the future?
The market has already shown that green initiatives are more profitable, because large investment funds are moving towards green investments and are willing to pay out the improved yields. Is the market also ready for green supply chains in which property can be part of a green contract, for example a European contract allowing flexible use of the property? Such a new contract will only be possible if the investment market is willing to be more flexible with regard to the cash flow generated by these contracts. Fund managers will not find it easy to adapt their strict contracts to the greener terms demanded by today’s world. In the end it will be the users of the logistics real estate alone who have the power to change things. They currently have the purchasing power to demand such contracts, and this means that logistics real estate needs a new business model for the years to come.
The current market is very fragile because new developments are slow to hatch, and any new deals are still being valued using current market figures. There are still many empty square metres of new, high-quality warehouse units around Europe. Of course, the owners of these properties are not happy, but eventually these properties will all be filled, and new developments will start to emerge. These new developments will increasingly be required to offer opportunities for value added logistics and services as the final processing of the product moves increasingly closer to the customer. Investors will adapt their views to the new warehouse standard as almost every user will have these requirements. It will also mean that leases will initially become longer, as the industry is not one to embrace change, but flexibility can be achieved with larger contracts. These large contracts will be the first steps on the path to sustainable supply chain networks. Logistics real estate represents centres of garvity in the supply chain that in themselves are inflexible. Nonetheless, the unpredictability of customer spending patterns will force companies to think in new business models.
So what would a new supply chain look like for a company using the CDC-RDC model? The main factor for deciding the location network strategy is the question to what extent the working capital should be allowed to determine the supply chain. In the old version of the lease contracts, companies needed to determine how much iron inventory would be needed for every DC to provide the market with the right customer service level. The duration of the lease would be based on this, as occupancy levels are always very important to ensure a smooth operation. If large European lease contracts were to allow operations to be scaling up or down within the CDC-RDC network, this would mean that the supply chain design could be based on a reduced iron inventory and a larger customer base. This makes it easier to minimise the storage costs in relation to the financial costs of the working capital.
The inbound side of the supply chain will undergo some minor changes in the near future. For example, a large number of tri-modal infrastructural solutions have been created to promote sustainable transport. Green incentives will result in an increasing number of companies using these transport modes. It is therefore important for investors to be present in these regions, since the new flexible business model will have a major advantage for the choice of location for the CDC. This choice will remain very stable if the outbound logistics strategy is based on a flexible choice of location for the RDCs.
At the RDC level it will not only become very important to be able to scale operations up or down in terms of square metres. Flexibility will also be needed in terms of human resources and equipment. This will make it possible to establish a very sustainable way of working for the future, which in turn will mean a new definition of flexible networks. The market is ready for new initiatives, but will we decide to take the long road to victory, or is it to be short-term benefits once more?
Erik van Wunnik