CITY: A COMMERCIAL ENTITY

‘New world’ cities have been growing as a consequence of inward migration: from rural to urban areas. In the ‘old world’, cities seem to be experiencing inward migration because populations have returned to formerly depopulated urban areas. We see that, for some key commercial and residential users, the city itself has become a commercial entity, capable of adding more value to an enterprise than a single building or business park.

In global markets and industries where access to human capital is more important than access to monetary capital, the value of location is more about what a place is than where it is. Homogenous, out-of-town business parks do not attract the most creative, skilled and in-demand workers. If the success of an enterprise depends on creating intellectual property, then cities that allow for chance meetings, imaginative encounters and the exchange of ideas are likely to be more productive than segregated work environments.

The benefits of agglomeration in world cities are the mixing and gathering of people from around the globe. The best cities combine arts, entertainment and culture with a benign business environment and wide range of finance, consultancy, administrative, legal and other support structures. In the short term, competition for assets has suppressed yields, but economic and rental growth should still provide returns for investors. Longer-term growth depends on the sustainability of these cities and their capability to continue attracting a talented workforce.

Threats to a city’s magnetism might be characterised as anything that starts to drive people out. Factors could be environmental: poor living conditions, pollution or uninspiring surroundings; they could be cultural or economic: job loss, brain drain or over-zealous immigration policies. Real estate costs themselves may start discouraging people from settling and could enable cheaper cities to outcompete for talent.

PRIZES FOR SECOND PLACE

Quantitative easing since 2009 has led to yield compression and a consequent surge in real estate prices, resulting in competition for opportunities in conventional asset classes in key cities. Private and sovereign wealth, as well as new Asian funds, joined the melee and demand for readily investable assets has soared – against a background of recessionary development inactivity and consequently limited supply. Yields are back to record lows in many first-tier cities.

We anticipate the rise of second-tier, second sector and secondary property as buyers seek out less heavily-invested cities showing good economic growth where returns can be achieved. Higher yields are available in secondary markets, even in first-tier cities where some prime to secondary spreads have rarely been greater.

Even the more conventional institutions will have to venture outside their comfort zones simply to become fully invested, competing with private wealth, private companies and sovereign wealth. On this basis, we like asset classes that have been less fashionable lately: main street retail in good US centres, secondary industrial estates with longer-term potential in key expansion locations, other potential change-of-use buildings and land, mixed-use development on intense urban sites, student housing in Europe, distribution warehousing and resort developments in global regions where leisured middle classes are burgeoning.

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THE RISE OF THE US

Stronger than expected GDP growth, job creation and rising incomes have all been positive for real estate markets in the US so real estate recovery has become more firmly established in many locations.

US real estate markets are highly domestic and are not reliant on overseas investors, despite attracting foreign capital. This means that the strengthening dollar does not discourage investment, even if US real estate is becoming relatively more expensive on the world stage. Perversely, this strength will even encourage some investors looking for safe-haven stores of wealth in solid denominations.

Asian investors and others are beginning to see their own region and some world cities appear fully valued, so are now casting their net toward the US. American cities with an international reputation, and the right stock, will attract more Asian buyers in 2015, despite a stronger greenback. Domestic US funds will be pushed toward smaller cities – especially those with a particularly strong recovery, regeneration or economic story. Our world ‘secondary and second-tier’ prediction will therefore play out in the US as well.

"Overall, the prospects look good for continued real estate recovery"

On the downside, low oil prices will suppress some growth in American cities isolated from the rest of the economy, notably Houston. Intractable socio-economic issues may continue to press on others, like Detroit. Overall, however, the prospects look good for continued real estate recovery, improved investment performance and rental growth, resulting in increasing domestic and overseas investor activity in many US cities.

EXPECT THE UNEXPECTED IN EUROPE

As the dollar becomes the currency of choice for real estate investors, appetite for euro-denominated assets is impaired by the ongoing saga within the European Union and the threat of a Greek exit. But this may cause some investors to miss out on excellent recovery performance in key European city real estate markets.

A very good example of second-tier city performance was shown in 2014 by Dublin. A combination of discounted values, misplaced euro worries and a stronger than expected economic recovery made it the best-performing European city of 2014.

The key drivers will be re-pricing and economic outperformance by certain cities. Germany’s outperformance tends to be hidden within some dismal eurozone forecasts, but is likely to continue in 2015. German cities where wealth is created and stored, like Dusseldorf, or which attract human capital and growing population, like Berlin, are likely to out-perform.

Fully discounted European cities, where there will be some economic growth, may also surprise on the upside. A distinct characteristic of recovering markets can be sudden, high rental growth from a low base. In cities where recession has meant no development, especially those with naturally supply-limited historic cores, demand upturn is met by supply shortage putting upward pressure on rents and paving the way for capital growth.

Taken from
Savills World Research: 12 Cities - H1 2015