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Emerald Group Publishing Limited
Article Type: Editorial From: Journal of Property Investment & Finance, Volume 33, Issue 6.
Sustainable investment, risk management and cities
It is definitely a mark of ageing when one of your former students becomes President of the Royal Institution of Chartered Surveyors. Martin Brühl – the first continental European to hold the position – took over the presidency in June 2015. In his inauguration speech, he identified two key themes: the promotion of sustainable investment (conceived more widely than a focus on the environment and encompassing the role of real estate in creating a sustainable and affordable urban environment) and the duty of fund managers to consider risk management (how can we behave rationally and responsibly in an historically low interest rate environment?). These themes are echoed in the World Economic Forum’s industry council on the Future of Real Estate and Urbanisation, with a mandate to identify a set of principles by which real estate can contribute towards sustainable, resilient urban development. Do patterns of global investment suggest that this is happening?
Global capital flows into real estate grew sharply in the run up to the global financial crisis, but declined sharply in its immediate aftermath. However, they recovered equally rapidly and are now back at record, pre-crash levels. In part, this has been driven by the search for yield: with governments in developed economies forcing down interest rates and bond returns, real estate, with its rental return, provides a cash return that looks attractive when government bond yields are offering negative real returns and provides some measure of inflation protection should quantitative easing trigger inflation in the future. Global flows have been reinforced by new players, notably the sovereign wealth funds, increasing allocations to real assets including real estate. But are the patterns of investment consistent with a responsible approach to risk management?
One striking feature of global investment flows is their extreme concentration. Despite persistent evidence of the sector’s relatively poor performance, nearly half of major investment transactions recorded by Real Capital Analytics between 2007 and 2014 were office investments. Focusing on offices, a startling 39 per cent of investment by value flowed to just five cities (London, New York, Tokyo, Paris and San Francisco), over half of investment transactions were in just ten cities of the nearly 400 urban markets recorded by RCA. JLL figures support this concentration: in their analysis of 300 cities, the top 30 "alpha" cities have 43 per cent of the GDP, 39 per cent of the office stock – but 62 per cent of investment activity. In ongoing research, we have analysed the location of the head offices of the firms and funds making this investment and they are equally concentrated: over 50 per cent of office acquisitions by value were made by purchasers with HQs in just ten cities – almost all of which are the leading cities for investment.
It is hard to justify this concentration of investment in conventional risk return terms. Although robust time series are hard to obtain, the consistent evidence suggests that these alpha cities, global cities, gateway cities have capital and total returns that are more volatile than the cities below them in the world urban hierarchy, yet do not offer higher returns to compensate for that enhanced risk. It is certainly true that office capital values in many of the target cities recovered rapidly after the global financial crisis (having experienced steeper falls in the crisis): but that recovery has been almost entirely driven by yield compression, in turn driven by the buying pressure in those markets. It is an easy mistake to assume that economic growth and rising GDP translate directly into higher rental growth: in practice, supply adjusts, albeit slowly, to increased demand and long-run evidence (e.g. for Amsterdam, London and New York) shows that long-run real rental growth is close to zero.
The agglomeration economies and gains from world city status may be captured in higher land values which, in turn, may be reflected in greater density on particular sites. However, to capture those gains requires development or redevelopment activity, which is inherently riskier than the core investments sought by many of the buyers in these markets and requires longer time horizons than many fund managers possess. More than this, the returns in the global target cities are more strongly correlated (as expected, since the economic drivers of performance and value are largely global in nature) and, hence, offer less diversification potential than non-core urban markets.
There are other explanations offered for the concentration of investment. One is that such cities offer greater liquidity. Certainly transaction activity is higher: but then the markets are larger too. In terms of turnover ratios, the evidence is more mixed. However, liquidity is priced: do investors with long time horizons really require that liquidity and should they be prepared to accept the lower returns it implies? Further, the more long term investors acquire assets in global cities, the less liquid they become! More important, perhaps, are logistical factors: these cities offer the opportunity to invest large amounts of capital quickly and to benefit from economies of scale and reduced search costs. This is facilitated by the offices of global real estate advisors (as concentrated as the investors and target markets) in those cities. Overlaying this are behavioural explanations: a belief that these are safe havens, the impact of the name and "brand" of the city, its familiarity and its accessibility to global managers.
Does this represent responsible investment and risk management? If creation of a global real estate portfolio is driven by the wish to capture diversification gains and obtain superior risk-adjusted returns, it is not clear that locking investment into cities that are sensitive to similar (global) risk factors and that are subject to contagion effects is rational. Moreover, the compression of capitalisation rates that has been driven by capital flows raises significant questions about expected returns, even given current low interest rates and government bond yields. If investors are anticipating that real estate in those cities will deliver "historic" average property returns (real or nominal), then they will need to obtain real rental growth (and to explain what will produce that growth), since capitalisation rates are unlikely to fall further and buying at low yields makes property values vulnerable to upward interest rate shocks. Alternatively, investors may believe that low bond rates and interest rates (and, by implication, low economic growth) will be sustained going forward: in which case, their return expectations should be substantially lower and their clients should be made aware of that.
How does all this relate to sustainable investment? Well, at one level, sustainable investment has to be economic and efficient and not destroy value. As real estate professionals and researchers, we have a responsibility to identify the risks to which portfolios are exposed and to develop the toolkits by which the risks can be identified. That might direct investment to different cities and to different sectors. For cities to be sustainable economically, they need investment: we need to identify where that investment is most productive, helping to create a more balanced urban network. In turn, that can contribute to dealing with issues of affordability, social inclusion and urban sustainability by shifting investment away from higher risk "conventional" investment sectors towards alternatives (housing, healthcare, infrastructure, education, for example). There is a growing recognition that such alternative segments of the real asset market offer real potential for investment while meeting corporate social responsibility targets.
Any discussion of sustainability and resilience has to consider environmental aspects. From a property investment perspective, there are normative issues (to what extent does our portfolio contribute to a sustainable environment?) and there are investment issues (to what extent is our portfolio exposed to environmental shocks?). For the latter, a key question is the extent to which environmental risks are reflected in prices; do greener buildings and portfolios generate better returns or reduce aggregate risk. Great strides have been made in addressing that question empirically, but many investors, unfortunately, remain unconvinced of the business case: in part, because of mismatch between (shorter) investment time horizon and (longer term) delivery of benefits; in part because of problems in allocating costs and benefits between landlords and tenants.
However, most research in this area has focused at the building level (or on portfolios as aggregations of buildings). Perhaps what is needed here is a refocusing of research and attention on the fact that real estate is fixed in location and, predominantly, fixed in particular cities. Recalling that reinforces the point that real estate investment and development need to contribute to urban sustainability. Work on resilient cities points to this: as an investor, your building may be resilient and sustainable: but that will be of little comfort if the city in which it is located is unable to withstand an environmental, economic or political upheaval which, for example, destroys or disrupts the economic and social infrastructure. To what extent are such risks assessed across global real estate investors’ portfolios? To what extent are such risks reflected in the price of real assets? There is a need for detailed research on that topic but just as an illustration: of the top ten target cities for office investment, seven are coastal and subject to surge flooding and sea-level rise; and three are on tectonic plate boundaries.