Investors in global cities should be able to share in some of the fastest growing parts of the economy and the best investment returns over the next few years, according to Hugo Machin and Tom Walker, co-heads of global real estate securities at Schroder Real Estate.
The world is urbanising. According to the United Nations, well over half of us will be living in cities by the middle of the century. The gravitational pull of global cities will only become stronger as employment opportunities continue to centre on a select number of urban powerhouses and real estate is the obvious way for investors to tap into this trend. There is a very close correlation between real estate and the wider economy, as our chart illustrates. Investors in global cities should be able to share in some of the fastest growing parts of the economy and the best investment returns over the next few years. The world is moving away from sovereign borders and is becoming defined by economically powerful global cities.
Fortress cities
Of course, not all cities are created equal. The best are economic fortresses. It is why we developed the Schroder Global Cities Index to help sort the winners from the also rans amongst the urban centres of the future. Our ranking of global cities looks at economic growth forecasts, including disposable income, retail sales and working population growth. Other factors we focus on to measure the competitiveness of a city include the provision of tertiary education, the quality of the infrastructure and the capacity of the transport system.
These factors are crucial: a top ranked global city needs to be able to move people, goods and data efficiently. In addition, the ability to interlink with other global cities – creating a network of physical and virtual links – becomes increasingly important to the economic health of a city. Cities that combine high rankings on these measures with the key ingredient of scale will continue to blossom. This creates a virtuous circle whereby economic growth funds infrastructure and research, which in turn spurs further growth and demand for real estate.
Cities that combine high rankings on these measures with the key ingredient of scale will continue to blossom. This creates a virtuous circle whereby economic growth funds infrastructure and research, which in turn spurs further growth and demand for real estate. The result, as Figure 2 illustrates, is that certain large cities have become economically detached from their hinterlands, generating higher growth than their host countries.
To be a global city requires diversity, not just in its population but also in its economy. Those that rely on a single industry or commodity remain at risk from specific shocks. Aberdeen, Alberta and Houston have all seen property prices slump with the oil price in the last few years. The variety of a truly global city should leave it well protected from such downturns.
The flat-white economy
One of the kaleidoscope of industries from which global cities are currently benefiting is the tech sector. A reflection of the growth of technology is the investment it is attracting from venture capital companies. Moreover, it is the global “gateway” cities – including London, New York, Tokyo, San Francisco, Shanghai and Mumbai – which are attracting the lion’s share of that investment, according to the Martin Prosperity Institute think tank. This should in turn raise economic expansion and employment, leading to strong rental growth.
Technology is just one part of the new 'flat-white' economy that has mushroomed in global cities. What marks out this phenomenon is rapidly evolving businesses that don’t need to be located in the heart of a city, but still want the benefits of city life (including the flat-white coffee beloved by young, upwardly-mobile workers).
These innovative companies need well-designed space. Their employees want to live close to their workplace and they want to spend their leisure time in interesting and innovative cafes, bars, restaurants and clubs nearby. Affluence is returning to the core of these constantly evolving global cities. All this is bringing life back to swathes of previously peripheral real estate, which is now commanding high prices.
We do not see this as a fad. Service-based companies recognise they need to be in offices and locations that fit with their workforce if they are to attract and retain high-calibre staff. The development of exciting workspaces in lively neighbourhoods is driving rents higher. In London, for example, the rents in the White Collar Factory on Old Street roundabout in the heart of 'tech city' have gone through the £70 per square foot mark. This puts them on a par with rents in the City of London, yet the building has still to be completed.
Threats
Right now, demand from tech companies is exceeding supply in the main gateway cities. Any threat to that demand will clearly hit their economies. However, we expect the impact to be less than in cities that have a lower ranking in our Global Cities Index.
The reason is quite simply the barriers to supply. In such global cities, the physical and regulatory barriers are such that they have become development “islands”, where the difficulties of building supports rental values. One example is Los Angeles. The city is effectively in a basin created by the encircling national parks and ocean, which prevents it growing outward. Nor can it grow upwards much, given the restrictions imposed as a result of Proposition U, which limits the floor area of redeveloped buildings.
One company that stands to benefit is Rexford Industrial Realty, a Southern California property company. Figure 3 plots the location of every asset the company owns. Most are clustered in south Los Angeles, close to the port, freeway and freight terminal. These locations are ideal for tenants looking to move goods into and out of the city. Furthermore, the properties benefit from the increasing needs of e-tailing. Customers want their purchases delivered ever more quickly and companies increasingly need to warehouse returned goods. Suddenly industrial assets in infill locations have become a lot more valuable than in the past. So proximity to infrastructure and supply constraints both put Rexford in a strong position.
Unequal cities
Outside of these top-ranked cities, minefields abound. The virtuous circle of economic growth can break down rapidly and become a death spiral. Detroit is case in point. The reliance on the car industry and a lack of investment has seen the arrival there of de-urbanisation: a city in retreat amid crashing real estate values. By 2010, according to the New York Times, the city’s population had fallen to 713,777, its lowest level for 100 years.
Detroit is classic example of a city that has suffered from its over-dependency on a single industry. When car making disappeared, land values collapsed. As a city in that situation depopulates, demand for land dries up and buildings are abandoned. This has a knock-on impact on inward investment, which federal and state funding can only do so much to cushion. Detroit shows how wary real estate investors need be when venturing beyond core global cities.
Conclusion
For investors, it is not possible to create a properly diversified portfolio by buying assets in these cities directly. The key is to have the research capability to be able to identify both the best cities and the companies which have exposure to them. That knowledge, we would argue, then needs to be put to work building and maintaining a diversified portfolio of listed real estate companies best placed to exploit the potential of global cities.