London, New York, Tokyo, Paris. When it comes to what is driving real estate investment decisions across the globe, it is the names of leading cities, not countries, on everyone’s lips.
Supercities, second cities, and even emerging cities are carving up what the World Economic Forum estimates will be a $1tn global real estate investment market by 2020.
And it is an investment approach that is gaining traction.
The Urban Land Institute and PwC’s Emerging Trends in Real Estate: The Outlook for 2016 report for Europe is packed with comments from developers, investors and fund managers that indicate a shift in focus. “New market opportunities are now cities rather than whole countries,” and, “we don’t invest in countries anymore, we invest in urban areas,” are just two of many.
So should cities trump countries as the source of main indicators to drive returns, and is this trend here to stay?
Clarity for investors
Fund manager TH Real Estate certainly thinks so. The company’s research, Picking Tomorrow’s World Cities, advocates a city-level approach to real estate investment as a way to give investors more clarity as to what their portfolio might look like.
It is also consistent with the way occupiers think about their requirements, says the group’s global co-head of research Alice Breheny.
“When you talk to a big corporate investment bank, it does not say it needs to open in the UK, it would say London or Edinburgh,” she says.
This is a view supported by James Whitmee, partner at EMC Real Estate, a consultancy specialising in opaque or emerging markets. He says corporate occupiers have a very strong view as to which city they should be in, especially for a headquarters.
“If a firm is considering opening in West Africa, it would be asking us to compare Accra with Lagos, not Ghana with Nigeria. Advice still has to be on a macro-level but we use other cities for benchmarks,” he says.
And money managers are also putting the approach into practice.
James Maydew, deputy head of global real estate at Sydney-headquartered fund manager AMP Capital, says: “We invest from the bottom up as opposed to the top down, but there is definitely a quality bias, focused on gateway cities over country exposure in the portfolio.
“You need to look at the underlying drivers of supply and demand. Doing that at the country level loses significant information and data, which could lead to poor capital allocation decisions.”
But whether or not you ascribe to a city-centric approach can depend on what type of investor you are and what type of investment you are looking for.
“If you are an office investor it tends to be cities [dictating investment decisions] because there needs to be a critical mass of stock, leasing activity and liquidity in a market in order for you to be investing there,” says CBRE’s head of EMEA research Neil Blake.
“Retail, on the other hand, has always been quite different to that. So for an international investor places that are completely uninvestable from an office perspective are considered perfectly natural locations for retail investors.”
He gives Portugal as an example, where if you were a global investor looking for offices, “the list stops at Lisbon and possibly Porto”. But a retail investor “would probably be quite happy to look at any town or city with a population of 50,000-plus as being perfectly capable of supporting a decent shopping centre”.
TH Real Estate’s Breheny agrees that a city-focused approach does not suit all investors. Take sovereign wealth funds, for example – a traditional safe-haven investor.
The well-trodden path for these investors making an initial allocation to real estate is usually an indirect investment followed by a joint venture or the appointment of an investment manager before making a direct investment.
But even in this case, when the first investment could be buying shares in a national property company, the ultimate goal, according to Breheny, is still exposure to the most liquid city market. The investor has just gone the long way around.
Up the risk curve
At the opposite end of the investment spectrum is a venture capital-style or opportunistic investor that is willing to go up the risk curve to drive higher returns.
For investors of this ilk, and particularly short-term investors looking for opportunities in structural or cyclical changes driven by economics or politics, is a country-level analysis essential?
Yes – for some, political risk is an attraction, says Breheny. But she adds that, for many, economic uncertainty makes a city-level approach even more necessary.
She says: “We advocate investing in cities rather than countries because there are markets like China, for example. It is a huge country to write off in its entirety because of the perceived macro risk, whereas in reality Shanghai might look very attractive.
“But there are some countries that, because of their high level of political risk, you wouldn’t invest in anywhere, and the city story doesn’t get to trump the country.”
One reason why this city-centric approach has become so popular comes down to the “megatrends” underpinning it. TH Real Estate identifies urbanisation, rising middle classes, ageing population, technology, and the shift of economic power from the West as the big issues that are having a major impact on the built environment and significant implications for demand for real estate.
The force of these megatrends – particularly urbanisation and technology – is expected to continue to give the cities the advantage over countries, says AMP Capital’s Maydew.
“We feel gateway cities will continue to outperform through the cycle, taking market share from less dominant cities and regional areas,” he says.
“This is being driven by a significant push to urbanisation supported by Generation Y and millennials wanting to work, rest and play in major cities and away from the suburbs and secondary markets. The trend is increasing the density of major cities and blurring the lines between work and social lives.”
Maydew adds that there is a high correlation between those cities that are achieving urbanisation success and those willing to spend significant capital on improving infrastructure.
This is echoed in the ULI and PwC Emerging Trends report, which points out that investors are identifying those cities that are responding to the pressure from increased urbanisation and are delivering the necessary development to service this pressure, such as infrastructure.
Breheny sums it up pithily: “It is important to note that it is about knowing where you don’t want to invest as well as where you do want to invest.”
Another driving factor behind the city-centric approach is diversification.
Breheny believes that it is cities, not countries, that best fulfil this requirement. Investors that consider the country they invest in before the city claim they have good diversification by investing in three different nations but they tend to invest in the financial districts of the leading city each country.3
The largest real estate markets are typically closely correlated, driven by financial and business services, and so offer little benefit to geographical diversification. Seeking a balance of occupiers by industry should help lower rental growth volatility, and avoid over-dependence on any one sector.
Investments underpinned by financial and business services, for example, should be complemented with investments in resource or commodity-led cities.
So this means looking at second cities and growth cities – or indeed emerging cities – to get the benefits of diversification.
Surely, as all these tiers emerge to build up a national picture in one country, the balance of power could swing back to looking at countries?
It is a possibility that cannot be wholly ruled out. But for the moment the truly global and truly diversified investor will continue to collect shiny assets in cities all over the world.
City-by-city investment: a zero-sum game?
While major and emerging cities benefit from increasing cross-border investment, does this have a trickle-down effect that will boost the economy of the country as a whole or does it result in all the investment pouring into one hub to the detriment of the rest of the region?
CBRE senior research director Michael Haddock does not believe it is a “zero sum game”.
“I would favour the view that it is an everybody wins-type scenario. Growth in your principal cities creates growth elsewhere. Having a successful main city adds to the growth of the country rather than just redistributing it,” he says. This is the case in the UK, where London has been instrumental in the eventual spread of cash to other cities. Without it, the UK could have suffered in its entirety.
However, TH Real Estate co-head of research Alice Breheny acknowledges that a side effect of the trend to concentrate investment on cities is growing polarisation within and among countries.
But this, she says, creates an opportunity for domestic investors who know the local market to step in, whether on their own or in a public-private partnership.
It is, after all, successful partnership projects that often catch the eye of international investors and can change the fortunes of previously overlooked destinations.
The power of global cities
By David Green, principal, Perkins+Will
I see the future city as one that will have an adaptable projection of the public realm, primarily as a tightly connected system of streets. There is a direct correlation between the connectivity characteristics of a city plan and its ability to change over time without redesigning the entire system. The two key characteristics are block sizes and intersections per square mile, or some variation of that metric.
Regulations will be minimised to the extreme and require only a few specific and important things. This will have the effect of increasing the homogeneity of the urban fabric and also raising the heterogeneity in the design and typologies of buildings. It is a bit counterintuitive, but it is the future.
Districts and neighbourhoods in cities will be managed much more like campuses, with district power, water reclamation, heat and cooling sources, and other resources. But they won’t look like campuses; they will look and feel like vibrant cities.
Data will play a greater role in driving development decisions. Interestingly, if cities are very smart, they will no longer be “planned” based on uses. I believe that land use-based planning is a failed model for creating the city of the future. Market will dictate the locations of particular uses, and the more overlap the better.
But as much as everyone is saying the future is digital, there is no substitute for the physical presence of people in cities, moving through public spaces throughout their daily lives. This will be facilitated by highly connected streets and presages a move to decentralised goods and services distribution. The days of the shopping mall and the office park are over.
Ultimately, cities of the future will be better designed. This will be the result of the removal of almost 100 years of pseudo-scientific planning methodologies, replaced by logical, simple, clear principles, which will free designers to be much more creative in the design of our cities of the future. We will, interestingly, get back to the Greeks and the idea of balance between art and science.