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Investing in tomorrow’s cities

Alice Breheny
— 1 minute read

Identifying future-proof cities is essential to building a successful portfolio of commercial real estate, writes TH Real Estate’s Alice Breheny.

Alice Breheny.

Global real estate is back on the agenda for institutional investors worldwide, and Australia is no exception.

On a recent visit to Australia, I was fortunate enough to speak with many local institutional teams about the opportunities real estate presents, and while all investors are at different points in their investment process, all are showing interest in the asset class.

Australia’s super funds understand that commercial real estate, both in this country and elsewhere, represents an attractive long-term investment opportunity and data confirms they have been lifting their allocations.

Data from APRA shows that the holdings of unlisted real estate of super funds with more than four members rose by 17.3 per cent to $64.3 billion over the year to the end of March.

Like their counterparts in other countries, Australian institutional investors favour commercial real estate, and retail property in particular, because of its low volatility, long lease terms and diversity of tenant base.

Of course, in real estate investing, as with all investing, it is important to ensure that the portfolio is properly diversified.

So, what does proper diversification mean? It means spreading a portfolio across cities that are most clearly beneficiaries of the megatrends that will drive investment performance over the long-term – these including urbanisation, rising middle classes, ageing populations, technology and the shift of economic power from the West towards Asia.

Economic cycles do have an impact on performance in the short term. However, it's megatrends that will matter much more over the long term, which is the time horizon that matters far more to many institutional investors.

Future-proof defined

That is not to say that tactical real estate fundamentals – such as demand and supply over the next two years or so – do not matter.

In fact, at TH Real Estate, we take them into account, along with the effects of the various megatrends, when we look for cities that offer the greatest potential for future-proof investment.

In this context, ‘future-proof’ means that the investment is unlikely to be affected much by fluctuations in the global economy or the national economy in which it is located.

In assessing the future-proofing of cities, we consider a number of qualities that make them attractive to people and occupiers, today and in the future. We assess cities on the basis of their current size, wealth, age profile, adoption of technology and way of life. We also consider the potential for growth in each of these aspects. 

Of course, traditional measures of real estate attractiveness also matter. We look at several hundred cities globally, and assess each of them on the basis of real estate liquidity, transparency, income security and volatility.

This approach means that we can concentrate our research efforts on a small minority of cities that are particularly attractive. In Europe, for instance, we focus on fewer than 50 cities out of a total of 200 for which we have data.

We think that these are the cities that have the greatest ability to attract talent, tourists and international tenants, on the basis of their long-term fundamentals. 

We then group the cities in three categories. Naturally, we want to concentrate on 'defensive growth cities' which, according to our analysis, look attractive now and in terms of their future prospects.

Examples of these include London and Munich. Of course, it would be wrong to ignore 'defensive cities', which have very strong fundamentals today. An example of these would be Paris.

On the other hand, there are some cities which, in terms of their traditional real estate fundamentals – such as illiquidity, lack of transparency or small market size – are clearly unattractive now, but have such high growth rates they cannot be ignored.

These are the growth cities, whose place in the hierarchy should change markedly over the next 20 years.

As economic output and/or consumer demand in these cities grows, perceptions of them as real estate markets should change for the better – with the result that rents rise and yields fall. An example of one such 'growth city' is Istanbul.

Diversification in practice

Once we have categorised cities as defensive growth cities, defensive cities and growth cities, we classify them as Tier 1 and Tier 2. This relates to their size and the scale of opportunity that we can identify, rather than their attractiveness.

Common sense might suggest that we would bias our portfolios towards opportunities in Tier 1 defensive growth and defensive cities.

However, as investors, we also want to maximise the benefits of diversification in terms of location, sector and drivers of demand.

The largest real estate markets – such as London and Paris – are typically closely correlated, as they are driven by financial and business services. This means that they do not provide the normal benefits of geographical diversification.

By looking for a balance of occupiers in terms of industry, we seek lower volatility in rental growth and an avoidance of over-dependence on any one sector.

Investments in cities that are dominated by financial and business services, for instance, can be complemented with investments in resource- or commodity-led cities.

Very often, it is the Tier 2 cities and the growth cities that offer the best diversification potential. This is why we think it is important to consider them for inclusion in commercial real estate portfolios.

Investing across different real estate sectors can offer further benefits. Not all of the cities that we are focusing on are appropriate for all sectors.

Quite often we target just one sector, and actively avoid the rest. In general terms, the Tier 1 cities, such as Barcelona, should be attractive for all sectors, while the Tier 2 cities, such as Bratislava, are usually attractive for retail or logistics.

In growth cities, the opportunities arise mainly in retail, because their expansion is usually underpinned by rising consumer spending or tourism.

We build our portfolios using a city-by-city approach that looks at long-term megatrends, as well as traditional real estate fundamentals. We look to achieve the right balance of risk and diversification, while taking advantage of short-term pricing opportunities.

In this way, we look to produce above-average returns, lower-than-average returns and moderate downside risks for our clients over the long term.

Alice Breheny is global co-head of research at TH Real Estate, London

 

Investing in tomorrow’s cities
Alice Breheny.
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