Sourcing Alpha in Emerging Markets
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This time last year, many pundits were calling for the demise of city living, but fast forward to today and there are signs of improving performance in offices and centrally located apartment markets.
Initially there were concerns about major cities’ resilience to the pandemic. As workplaces closed due to the impact of COVID-19, shifts toward flexible work arrangements and preferences among households for more space and amenities on offer in suburban areas threatened to put an end to life in the big city.
Such fears turned out to be short-lived. A sharp increase in hiring intentions globally is underpinning a positive outlook for employment growth in 2022, and space requirements are rising. Mainstream property types in central business district (CBD) areas are now reporting rising demand and seeing signs of improved rental growth.
As for the office recovery story, it’s still in the early days. Demand remains subdued on an absolute basis, but it appears to have turned a corner on the backs of workplace re-openings and as a result of corporate tenants’ starting to make previously delayed long-term location decisions. Rental growth has now turned positive in aggregate across global gateway markets (see exhibit), with rising competition for a small pool of available modern grade-A space driving rents higher in such markets as Munich, London, Paris, and Singapore.
Unlike during 2020, when suburban markets held up better (our Best Ideas piece last year envisioned the resurgence of that market), CBD areas are now outperforming other submarkets. And even though that is a nascent signal that emerged only in the third quarter of 2021, there are several reasons to expect the pattern to continue into 2022.
One reason is that CBD rents tend to rise more quickly than in suburban areas when hiring intentions are elevated — as they are in today’s market — because businesses are compelled to use location as a way to help attract talent in a competitive labor market.
A second reason is that CBD markets simply tend to outperform in a recovery. During the past two recoveries, CBD rents grew at double the pace of suburban markets in the four years after reaching a trough. A drop in rents in the past couple of years has boosted affordability in previously expensive CBD locations, and slightly higher vacancy compared with pre-pandemic levels means improved choice, paving the way for rental growth during the expected demand upswing.
A similar pattern is playing out in major apartment markets, where household-location decisions are linked to employment prospects as well as such factors as amenities and accessibility — and, of course, whether workplaces are open or not. After a struggle in 2020, as workplaces have reopened and firms are hiring again, apartment demand has rebounded sharply in major cities, and rents are rising at a rapid pace. The most notable increases are in London and U.S. cities such as Boston and Washington, D.C., that are regaining lost ground after a sharp correction in 2020.
While the pandemic is far from over, and concerns about higher inflation and rising market interest rates persist, the backdrop for real estate markets in 2022 is one of transition to a new phase of recovery and expansion. Leading indicators are pointing upward, and even though the gap between the best- and worst-performing parts of the market remains wide, most sectors and regions are set for improved investment performance in the year ahead.
That renewed optimism raises a new challenge for investors: deploying capital that has been raised. But city office, apartment and retail markets that suffered during the pandemic are starting to come back into favor, and capital is increasingly finding its way into higher-returning operational assets, wherein returns are linked to long-term trends such as digital transformation, aging populations, and environmental sustainability.