What is driving demand in gateway cities?

Matching data from the Urban Land Institute and PwC’s Emerging Trends in Real Estate 2023 report for cities across Europe and Asia-Pacific with MSCI Real Assets’ transactions data for the year through October 3 shows a strong correlation between the top cities chosen in the ULI/PwC report and recent purchasing activity. Most of the top cities chosen for future investment prospects appeared in the list of top cities by completed transactions.

This is not surprising, as cities such as Tokyo, Singapore, London and Paris are large developed markets that are consistently popular with investors. For example, Tokyo has been a top five investment pick by ULI members in eight of the past 10 years.

These global gateway cities have growing populations, are home to major industries and are familiar to large and growing global investors. In July, London saw its first major office deal backed by private Vietnamese wealth, with the £209 million ($255 million; €213 million) purchase of Lion Plaza.

Flight to quality

Tom Duncan, head of research and investment strategy at Cromwell Property Group, says: “We see strong prospects in the global gateway cities which provide unrivalled agglomeration of industries and skilled labor. Cities like London, Paris, Amsterdam, Berlin and Milan are projected to see outsized GDP, employment and population growth over the next decade and benefit positively from business migration.

“They are investing in infrastructure, have strong cultural offers and support diverse economies leading to a range of occupier profiles. Demand for new space within these cities is acute, creating compelling investment options for savvy investors. Increasing worker and residential populations require additional logistics space in their hinterlands too, especially as urban land for logistics uses within these cities continues to be converted to higher value uses like residential.”

Since the pandemic, there has been a distinct flight to quality by occupiers and investors, particularly in the office sector, but in other sectors too. Part of this has been a preference for gateway cities or core areas of larger cities.

Rob Wilkinson, Europe CEO at investment manager AEW, says: “Investors are favoring markets that are benefiting from sustained demand and lack of supply, such as Paris, Berlin and London. Even if take up in 2023 is somewhat lower, the lack of supply in the most sought-after CBD markets has kept vacancy levels low. “In Paris, we have seen vacancy levels decline in the CBD Golden Triangle in the first half of 2023 to around 2 percent and just under 3 percent in the best locations in Berlin. Equally, the West End in London has seen rents increase to above £150 per square foot, and for new space in the City, rents are now at £100 per square foot or above. But peripheral and secondary markets are suffering by comparison.”

Asia’s star cities

Meanwhile in Asia-Pacific, there is a gulf between the most popular markets with investors and the rest. MSCI data shows the transaction volume for the top five cities was 50 percent greater than that of the next 20 most active cities. Tokyo investment volumes were roughly equivalent to those of the 15th to 25th most active cities combined.

Tokyo clearly bucks the overall Japanese demographic trend, says Shaowei Toh, head of research and strategy, Asia-Pacific at Savills Investment Management. “As a major urban center, people continue to move to Tokyo for better work and lifestyle opportunities. This migration is a major driver of demand for commercial real estate in Tokyo. The city has seen a rebound in population since 2022, and the momentum is going strong. As at [the end of] August 2023, cumulative net internal migration is already at close to 75 percent of 2019 figures.

“As well as ongoing demand for multifamily residential, we see opportunities in upgrading large parts of the inventory in urban locations to create best-in-class, sustainable, modern real estate. For example, in the Greater Tokyo region, only 10 percent of existing logistics facilities were constructed after the year 2000.”

Seoul has been one of the best-performing office markets in the world, despite the effects of covid, rising interest rates and a slowing global economy. Office vacancy is close to record lows there, and it was the second-most active Asia-Pacific city for transactions, despite relatively few cross-border deals. That said, international investors are looking for opportunities in the city.

Hong Kong has not been popular with investors surveyed by the Emerging Trends research and had been falling out of fashion with investors, not making it into the top five of Asia-Pacific cities in either 2021 or 2022, though it has begun to recover this year. The city’s office market remains oversupplied. However, retail rents have begun to recover with the resumption of tourism, and Savills is predicting rental growth of 10 percent this year.

“Attractive entry price opportunities will be available in Hong Kong, but they will be best for full equity buyers as leverage is not immediately accretive,” notes AEW’s Nelson.

While the larger gateway cities attract more namechecks from investors and more capital, there are still smaller cities attracting attention.

“We use a VIBE framework based on identifying cities that are Vibrant, Integrated, Balanced and Environmental that uses both quantitative and qualitative metrics,” says Cromwell’s Duncan.

“The lifestyle appeal of second-tier cities with VIBE characteristics also supports interesting investment opportunities. Places like Copenhagen in Denmark, Stockholm in Sweden, Manchester and Birmingham in the UK and Hamburg in Germany are areas of focus for us, too. “Their smaller size offers more ability for workers to live, work and play in a smaller area. In these locations, we see potential to pursue a brown to green office strategy given the lack of good quality, sustainable modern offices, as well as logistics value-add investments.”

Little distress

MSCI data for the cities which have shown the highest growth in transaction volumes from 2022 to 2023 highlights Manchester and Liverpool in the UK, as well as Hanover in Germany.

In Asia-Pacific, volumes in Kuala Lumpur more than doubled, while Chengdu, Kawasaki, Hangzhou and Chiba also showed strong growth. Both Chengdu and Hangzhou are smaller Chinese cities which are rated highly for livability, education and technology.

While pockets of distress have appeared in both regions, investors said they did not see much evidence of distress so far, especially in Europe where valuation falls have been somewhat muted and occupier markets remain surprisingly resilient.

In Asia-Pacific, Nelson suggests Sydney and Melbourne may offer opportunities due to low occupancy and a difficult refinancing environment. However, both cities have “a good long-term outlook,” he says. He also points to China’s Tier 1 cities, although notes that there is a lack of transactions on which to base pricing.

A notable feature of the European real estate market in particular is that a number of market participants felt there was little point in picking the ‘best’ cities for investment, as most of the continent’s larger cities offered opportunities depending on what strategy investors were undertaking.

“The changes in occupational trends have led to a bifurcation with the best office assets remaining sought after compared to those in secondary locations or offering less amenities,” adds AEW’s Wilkinson. “For prime offices in the right location and offering the amenities and facilities that occupiers are looking for, there is still competition for space which is pushing rents higher.”

Tech sector remains major driver of city fortunes

Some smaller cities have turned to specializations such a electronic component manufacturing

Despite the shine coming off some of the largest US tech stocks, the industry has become one of the most important drivers of city growth, directly benefiting the industrial, office and residential sectors.

While the leading US technology and life sciences markets are a main focus for investors, more are looking at the best Asian and European cities as well.

Savills’ Tech Cities research scores cities based on factors such as business environment, tech environment and talent pool. The top cities in the Asia-Pacific and European regions are Beijing, London, Shanghai and
Paris.

“Big cities are back in vogue as the effect of the pandemic has eased, though smaller cities that offer more affordable living, easy access to green space and outdoor pursuits are also in high demand,” says Paul Tostevin, director, Savills world research.

While the larger tech cities have a diversified range of companies, Tostevin notes that others have specialized, “applying technology to legacy industries or pioneering new ones.” For example, Glyn Nelson, portfolio manager, Asia-Pacific at AEW, says that Fukuoka, on the southern island of Kyushu, Japan, “benefits from the high-tech semi-conductor boom in Kumamoto, as evidenced by the rise in local electronic component and machinery inventory.”

While China has fallen out of favor with global investors, the importance of its technology industries is shown by its prominence in Savills’ Tech Cities rankings, which features 10 Chinese cities in the top 30, compared with only three from the whole of Europe.