After years of compression, logistics cap rates are under pressure to expand as central banks across the region continue to hike interest rates in the fight to control inflation. Pricing discovery started to take place in several markets, most notably in Australia and South Korea, with cap rates expanded in the past few quarters (Exhibit 3).

But capital values have been holding up relatively well thanks to stronger-than-expected rental growth (Exhibit 3). In 2022, Australian logistics markets in Sydney and Melbourne experienced record annual rental growth of over 20%. Similarly, Seoul saw nearly 10% rental growth. The overall logistics sector in Asia delivered over 5.2% real rental growth in 2022, despite the elevated inflation rates. Higher rents are helping logistics assets offset the negative impacts from yield expansion in these markets. As we expect pricing to continue recalibrating in the regional markets, with further expansion in logistics cap rates expected in 2023, rental growth remains critical to support asset values.

However, with major economies in the region reopened fully and economic activities normalized, the pandemic-driven surge in logistics demand has slowed across key cities. Following aggressive expansion in the past 18 to 24 months fulfilling logistics demand of e-commerce players and related third-party logistics (3PLs), leasing activities
moderated gradually. While high-quality logistics assets in desirable locations continue to record solid leasing performance, vacancy grew increasingly sticky in certain submarkets and the moderation of demand started to weigh on the rental growth outlook.

While headline rental growth is likely moderating, strong rental uplifts in the past two years have created a significant gap between in-place and market headline rents, implying rental reversions for assets having lease renewals coming. Taking the Sydney market as an example, in-place rents estimated for an asset with a 5-year lease started in 2018 and annual in-lease rental escalation of 2.5% would be approximately 30% below the nominal market rent level in 2023 (Exhibit 4, left chart).

Using the same methodology to assess potential rent reversions, we estimate that there is a broad-based presence of under-rented assets in several markets such as Sydney, Melbourne, Tokyo and Singapore (Exhibit 4, right chart). Estimated rental reversion averaging over 10% across the key cities in the next two years is well above the inflation rates forecast of 2.6% p.a.3. The rental reversion potentials, together with more modest but still solid rental growth prospects across major markets, are crucial cushions to support capital values against the risk of further cap rate expansion.

As such, while asset location remains critical for leasing performance as occupiers grow more selective,
we expect that valuations of logistics assets in established submarkets with shorter weighted average lease expiry (WALE) - hence offering faster mark-to market rental reversion - will be more resilient and present more attractive investment options to investors in the near term.