In a low-risk portfolio, New York is considered the most attractive office investment and Beijing and Shanghai the least attractive, according to a new global city ranking. Sotiris Tsolacos and Jeffrey Havsy report

The barriers to investing globally in real estate have fallen dramatically over the past decade - in particular the psychological barriers of US investors, most of whom previously viewed their home market as large and diverse enough and demanded large premiums to invest abroad. Things are changing:  a recent IREI/Kingsley survey showed that US pension funds increased their international allocation to 4% in 2007 from 0.6% in 2005. That is still a small proportion of their overall portfolios, but a dramatic increase over a two-year period and a trend that is expected to continue.According to a study by Prudential Real Estate Investors, the US accounted for 36% of the investible commercial real estate universe in 2002.1 Using the same methodology with updated assumptions, we estimate that by 2011 the US will account for 30% of the commercial real estate universe. Japan's share of the investible universe will fall from 15% to 10% over the same time period; at the other end of the scale, China moves from 1% to 6%. Many investors viewed 2007 as a time to enter emerging markets, and 2008 or 2009 might be a time to return to the US or London, which might offer buying opportunities because of current pricing corrections that might well overshoot. Capital flows have grown more global overall. Foreign investors have become much more important as investors in US commercial real estate, accounting for $51bn (€35bn), or 10% of transactions in 2007, up from $12.7bn, or 7% of total investment sales in the US in 2004. There is a similar situation in Europe, where cross-border activity has continued to increase. Total direct real estate investment reached more than €244bn in 2007, with cross-border investment 63% of this total (or €154bn), compared with just 29% in 2000.2  According to Real Capital Analytics, 32% of institutional property sales globally in 2007 were cross-border, totalling $340bn. Of the $340bn in cross-border transactions, 52%, or $177bn, involved purchases by buyers from the same continent. European buyers accounted for 75% of that.As for all investment decisions, the key issues for global real estate investors relate to the relative risks and returns. For this reason, insights into the relative attractiveness of different markets are needed to capture the dimensions of risk and the underlying drivers of performance. To help with this process, PPR has created the Global City Office Index. This version of the index ranks 18 global cities (five US, six European, and seven Asian markets) on a number of factors and is calibrated towards investors at the safest end of the risk spectrum.

The risk and return characteristics of cities reflect many diverse forces. In our analysis we have classified these determinants of city risks and returns into three categories:

National and metropolitan economic dynamism; that is, drivers of economic growth in the country/metropolitan area; Real estate market performance; Real estate risks.

Several variables are used to capture economic dynamism, real estate performance and real estate risks. Economic dynamism is captured by variables including the scale of economic activity, the cities' importance as centres of global business (number of major headquarters, presence of global firms, airport connectivity, etc.); and softer/qualitative factors, such as attractiveness as places to live, the degree of innovation, and economic structure. For the category of real estate performance we use both historical data and forecasts from PPR to assess in what stage of the cycle markets are in terms of demand, supply,  vacancy and rent growth. Real estate risks are measured with reference to market fundamentals risks (eg, deficient demand in relation to supply, high projected vacancy), investment risks (transparency, liquidity and PPR measures of market volatility) and measures or benchmarks of property performance. The ability to benchmark is a big step in determining risk. We have systematically analysed the information these drivers carry under each category, and this information is combined and classified very efficiently to categorise the differential attractiveness of the geographies considered. Our methodology identifies patterns in our dataset and allows us to produce a score and a ranking for each location. The scores, converted to percentiles, measure the spread between different cities, and they are calculated for each of the categories above (economic, risk, and performance). Subsequently, we aggregate them to establish overall market attractiveness.

 2008 index results:
Economic dynamism

When all three economic sections are put together, Tokyo ranks first (see figure 1), a bit of a surprise to those who think of Japan as a slow-growth country, which it is. However, Tokyo is still growing while the rest of Japan stagnates, drawing population and workers from other parts of the country. It remains the dominant economic centre in Asia, with more Fortune 500 and airport connections than any other Asian metropolitan area. These factors offset Tokyo's slow GMP and employment growth. Paris and London, the powerhouses of Europe, are ranked second and third, with New York fourth and Beijing fifth. Surprisingly, Shanghai is ranked last, dragged down by the quality of life, poor airport connections, few Fortune 500 companies, and a high cost of living.What pushes Paris, London and New York to the top of the rankings is their position as leading economic hubs in their region, number of Fortune 500 companies headquartered in the city, highly rated airport connections. Shanghai ranks last due to few Fortune 500 headquarters, limited airport connections and quality of life issues. There are differences in the rankings between components. For example, Beijing and Seoul are the clear leaders in city-level economic growth followed by London, Shanghai, Washington DC and Tokyo. However, Beijing and Seoul are dragged down by some of the same economic factors that hurt Shanghai.

Real estate performance

Many of the Asian markets are top performers due to strong demand and relatively high yields. Shanghai, Seoul, Beijing, and Singapore all score high with respect to current yield, historical performance, and future demand, and therefore take the top four rankings. In contrast, Tokyo ranks last and Sydney 12th, the only Asian markets outside the top 10. Given Tokyo's high ranking in the economy, why is its real estate score so low? Tokyo's upside is limited, and downside risks are myriad: an end to the recovery, under current monetary conditions as the US stumbles, could well plunge Japan into another prolonged funk. Investors, exuberant about the country's renaissance, might well have created asset bubbles in the real estate market. Foreign investors make up a sizeable proportion of the market, and their profit-taking could lead to value corrections. While the intrinsic value of land in central Tokyo should keep prices there buoyant, the less desirable suburbs are even more sensitive to the city's changing fortunes.
New York is the highest-ranking US city at number five despite a troublesome near-term outlook; it will solidly outperform over the forecast. The joyride is now over and, for the first time since 2001, New York investors are facing flat values at best over the next year. Still, New York will fare much better than most metropolitan areas in terms of value growth, thanks to superior NOI growth. Even as cap rates increase from their cyclical low of 5.3% at the end of 2007, they will only move up about 70 basis points over the next five years, so NOI growth will more than offset that rise. The most troubling facet of this market is its volatility. If the nation falls into a deeper recession, New York could take a disproportionate hit. London leads the European cities at number seven. The current and short-term picture in this centre is not rosy but in the medium term the flattened occupier market activity will pick up again. The recent sharp repricing has also made this market quite attractive internationally with investors eyeing opportunities.

Real estate risk
In the overall risk rankings, Zurich is the least risky market, followed by Munich and New York. Zurich ranks first because of a low supply forecast and relatively low return volatility, and New York and Munich have similar characteristics. All of the Asian markets are in the top half of the risk rankings, led by Beijing, Shanghai, and Seoul, which are extremely volatile and have a lot of supply. One surprising result is that Tokyo ranks as the fifth-riskiest market, even though vacancy is low and supply is moderate; the high ranking is due to high return volatility. However, the gap between Tokyo and Chicago, ranked 10th, is relatively small. Madrid, the third-riskiest market, is the only European market in the top half of the rankings. High supply is the main driver of Madrid's ranking. Not surprisingly, San Francisco is the riskiest US market, at number seven, and ranks third from the bottom for return volatility and highest for vacancy. Market risks can sometimes be related to levels of market maturity, because of the greater volatility of emerging markets, both in market fundamentals and in performance. But some mature markets, such as Hong Kong (ranked last in volatility of total returns), San Francisco (16th) and London (15th), also tend to be volatile. Whereas volatility in developing markets stems from poor transparency and speculation, in these mature markets it is more related to capital, planning restrictions/land restrictions that lead to lumpy additions to supply, and employment volatility. Certainly, these markets have had dramatic changes in capital flows that have influenced returns, causing developers to face difficulties in building new projects. The long lead times result in construction delivering late in the cycle and developers finishing projects regardless, since stopping and starting is so difficult. All three markets have also suffered during major financial and technology employment downturns.

Overall attractiveness for institutional investors

The overall ranking combines the three previously discussed sections. Once again, factor analysis is used to weigh the pieces and determine the final rankings. These results are most useful for investors who desire to keep their allocation and investments at the lower end of the risk spectrum. The top-ranked overall market is New York. It scores high on the economy (fourth), real estate performance (fifth), and low on the risk scale (16). Despite the current retrenchment of employment in the US, New York is a market that should be closely examined by long-term, lower-risk investors. The capital markets turmoil may offer buying opportunities or pricing discounts, though slight, that are advantageous for someone looking to hold assets over a longer term.
Los Angeles is the second-ranked market. Despite scoring low on the economy at 15 because of poor quality-of-life scores, Los Angeles finished sixth in returns and fourth in risk. Los Angeles has low supply, steady demand, moderate volatility, and a good yield relative to many of the other markets. These factors push it to the top despite modest economic numbers.London and Paris are the next two markets, both scoring well on the economy section and in the middle for performance and risk. The softer economic issues, but strong airport connections and Fortune 500 companies — where it ranks first and third — drive London's economic score. It is also the top market for GDP per capita. Paris is ranked third and second for airport connections and Fortune 500 companies. Total employment is another strong driver in Paris's economic section.
Singapore and Seoul come next, the first two Asian markets. Real estate performance pushes up their rankings, and Singapore's risk resembles that in London and Paris, in the middle. Seoul is riskier, which makes sense because of the supply forecasts, but is one of the best return performers.  At the bottom of the rankings are Shanghai and Beijing. Since this index is geared towards lower-risk investors, these fast-growing, high-return markets are penalised. However, they are riskier, and that hurts the overall score, overwhelming their strong economic growth and real estate performance. These two markets are likely to score high in the rankings for investors who are less worried about risk and willing to move further out on the risk spectrum to look for return.

1Yuoguo Liang and Nancy M Gordon, ‘A Bird's Eye View of Global Real Estate Markets', Prudential Real Estate Investors, March 2003
2Jones Lang LaSalle, European Capital Markets Bulletin, 2004 and 2007

Sotiris Tsolacos is director of European research at Property & Portfolio Research
Jeffrey Havsy is global strategist at Property & Portfolio Research