In Gateway Cities, Are Investors Seeking Pure Yield—or Something More Subtle?

Major U.S. markets like New York City are an evergreen attraction to foreign investors, as are gateway cities around the world. But returns tell a more complicated story.


New York is often called a global gateway city, a phrase that calls to mind its status as a mecca of international commerce: one among a select group of critical nodes in the world economy with an unquestionable rank among the most magnetic destinations for real estate investment. The Big Apple, London, Paris, Tokyo—it seems almost self-evident that these hubs of finance and culture ought to be international investors’ can’t-miss first choices for buying real estate abroad.

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But is New York City’s prime place on the list of sought-after real estate markets a simple matter of dependably eye-catching yields?

According to New York-based financial indexer MSCI, not necessarily so.

In research published late last month, the firm studied 10 years of data to suss out whether those four cities—outstanding by so many measures—consistently outperformed their peers in the returns they offered to real estate investment. The authors’ findings defied the conventional wisdom that gateway cities are a surefire bet for solid returns.

“Our analysis found the office sector in global gateway cities did not provide superior unadjusted returns over the decade ending 2016, based on annualized total returns,” Amit Nihalani, the paper’s lead author, wrote.

Instead, it’s a collection of deeper, less tangible virtues that keeps cities like New York the world’s most compelling investment opportunities.

Beyond the gateways

Pure capital growth in gateway cities did indeed outshine price increases in lesser markets over the last decade, a trend that was likely driven by barriers to supply creation in big cities as demand for well-located professional office space recovered following the financial crisis. But income returns in gateways tended to lag behind what regional and third-tier cities offered, making a rank-order list by annualized total returns of the 81 locations studied a muddle of gateway cities, regional centers and surprising competitors.

Three South African cities, Durban, Johannesburg and Cape Town—none of which is considered a global gateway—were the top global performers between 2006 and 2016, each with an office market earning annualized total returns above 12 percent. Vancouver, Canada, and Melbourne and Adelaide in Australia—three cities that don’t even make MSCI’s third tier of global significance—rounded out the top six.
By contrast, London—the highest-ranked global gateway—came in at No. 26, with an annualized total return just more than half those of the highest-performing metropolises.

That makes a catholic attitude towards capital allocation essential for those seeking yield at a time whenever more investors are considering deals abroad.

“Amongst our client base, we see a general interest in investing more globally,” said Will Robson, MSCI’s London-based head of real estate research, in explaining what prompted the study. “Pan-regionally, you also see a lot more investors talking about city-based strategies, as opposed to national markets.”

Traditionally, investors have been less facile with adopting foreign real estate than they have been at exploring corporate equities across borders. And when buyers do venture into real estate markets farther from home, they might be too intimidated to feel comfortable with spending in any but the most well-understood markets—which might impede them from finding better prospects that lie far from the beaten path.

“If you compare real estate to equities, there’s a much stronger domestic bias in investors’ [real estate] portfolios,” Robson said. “Understanding the dynamics in a large number of cities is operationally difficult.”

Adjusting total return for national effects dampened the researchers’ results, suggesting that within a given country, gateway cities could well be the best bet. Once national growth rates were subtracted from the data, San Francisco was tops in the world, with real estate assets growing nearly 3 percent faster than the broader U.S. London came in sixth, outpacing the overall U.K. rate by about 2 percent.

But the data suggest that country-agnostic investors looking for yield should give second- and third-tier cities the world over a careful look. Ten smallish cities in North America, Africa and Australia—places like Perth, Australia; Winnipeg, Canada and the South African trio already mentioned—outpaced even Europe’s best performing market, Stockholm.

The problem is that that strategy often runs up against what investment boards and credit committees need to hear before becoming comfortable enough to give international spending the okay.

When foreign equity funds and sovereign wealth funds “are trying to appeal to investors at home, they can sell New York, and they can sell Chicago. But in Shanghai, they might not know what Charlotte, [N.C.] is,” said Michael Wolfson, who researches capital markets for Newmark Knight Frank. “A lot of international investors, after they do a couple deals in safe-haven markets, they move onto where the yield is.”

To be sure, some do. GIC—Singapore’s sovereign wealth fund—and the Canada Pension Plan Investment Board have teamed up to become major equity players in U.S. student housing markets from Arkansas to Minnesota, laying out nearly $3 billion over the last 12 months in an effort to gobble up assets with good income returns. (Neither company offered a comment for this article.)

But in general, foreign real estate investors may hew to a traditional gateway-city approach because they are not as single-mindedly yield obsessed as some of their domestic-focused counterparts. Instead, other perks not on offer closer to home may entice them towards marquis real estate hubs like New York City.

Steady as she goes

Indeed, a remarkable confluence of factors—not just yield—would appear to have produced a golden moment for foreigners to invest in real estate in America’s biggest cities. For one thing, investors are attracted by the idea that New York City real estate is permanently enticing.

“There is a tremendous amount of liquidity [in New York City], which you don’t have in secondary and tertiary markets,” said Robert Knakal, the head of New York investment sales for Cushman & Wakefield. “While your yields may be higher [in smaller markets], your exit may be less certain. Here, over the past 50 years, the peak of each successive cycle has exceeded the peak at every prior cycle.”

Wolfson agreed, pointing out that wealthy individual investors from abroad treat their New York real estate holdings like cash deposits. The prime virtue in holdings there is in value that can dependably be withdrawn in a pinch, regardless of how well it appreciates.

“If you’re a high-net worth individual overseas, [investment in gateway cities] is more of a bank account,” Wolfson said. “It’s more or less about keeping the cash at the levels they bought it at.”

Of course, a liquid savings balance counts for little if the bank holding it isn’t reliable, so relative stability is another crucial mark in America’s favor. As volatile and gridlocked as American government has grown, it still may compare favorably to local practices abroad.

“If you look at America from an American’s perspective, we think our political system is dysfunctional. But if you look at us in the context of a global economy—and from a global political perspective—we offer significant political stability,” Knakal said. “We offer economic stability relative to most places around the world.”

Indeed, the U.S. might appear a stable investment destination not in spite of today’s raucous political environment, but because of it.

“I actually think that some of the turmoil in Washington has demonstrated the stability of the institutions [of government],” said Doug Duncan, the chief economist at Fannie Mae. He pointed out that on inflammatory political and social issues like immigration reform, gun control and corruption, politicians still defer to courts’ legal rulings and interpretations, demonstrating that the rule of law still holds more sway here than any interest group or political initiative.

That might be more than you could say of China, which recently, by all appearances, detained Wu Xiaohui, the head of one of its largest insurance companies, Anbang, for six months before even indicting him on ill-defined charges of “economic crimes.” Anbang maintains significant U.S. real estate holdings—New York’s Waldorf Astoria and Essex House are among more than a dozen American hotels the company controls—positions rumored to be up for sale now that the Chinese government has seized control of the firm.

The lack of transparency with which the Chinese government has proceeded only underscores the comfort that America’s legal foundation offers foreigners.

“If you are a very wealthy person somewhere around the globe, you have [good reason] to feel very, very confident about deploying capital into the U.S.,” Knakal said.

Even the most basic quality-of-life issues, largely taken for granted in New York and other gateway cities, may be less of a sure thing in some of the high-growth markets MSCI singles out. Cape Town, South Africa, for example—one of the cities that performed the best over the past decade in MSCI’s data—has been suffering through a calamitous drought since 2015, creating a water shortage exacerbated by a swift population expansion that has outpaced the city’s infrastructure. Without a deluge of summer rains or a massive new effort to desalinate seawater, the city is expected to run dry of potable water by mid-July. BusinessTech, a South African website for business news, found in interviews with local companies and government officials that many fear that if “Day Zero” (the date on which the municipal taps get switched off and Cape Town dwellers are allocated a daily ration of 25 liters) arrives, the economy could grind to a halt.

To make matters worse for property investors, South African lawmakers are moving towards a constitutional amendment that would grant the government permission to seize privately owned land without compensation at will, raising a long-term threat to the sanctity of the nation’s property rights.

And Cape Town isn’t the only city where impressive returns to real estate coexist alongside existential risks. Seoul, South Korea’s real estate market has yielded higher returns than any American city other than San Francisco over the last 10 years, but its position just 25 miles from the North Korean border would likely make the South Korean capital North Korea’s first target if tensions between the countries boil over into a military conflict.

America’s immense military power helps ameliorate similar concerns when investors look at opportunities here. Their interest in U.S. real estate as a stable place to park assets is decidedly manifest “in terms of international security,” Duncan affirmed. “The U.S. has bar none the world’s strongest military. [That represents] an investment in maintaining lines of trade.”

It’s the macroeconomy, stupid

For all the political factors undergirding foreign investment in America’s premier gateway city, the underlying economic environment the United States can pitch to international financiers today may be the most compelling attraction of all.

Although some monetary economists argue that the Federal Reserve was less proactive in counterbalancing the financial crisis and the subsequent recession than the conventional wisdom suggests, none can deny that America’s central bank responded far more aggressively than its European counterpart. From the second half of 2007 through the end of 2008, as the U.S. banking system threatened collapse, the Fed cut the federal funds rate 97 percent to nearly zero from a hair above 5 percent. The European Central Bank (ECB), on the other hand, responded much more gradually: its 4.25 percent headline rate in mid-2007 didn’t fall below 1 percent until five years later.

As a result, a relatively strong U.S. economy recovered much more quickly, enough so that the Fed became willing to begin raising the federal funds rate again at the end of 2015—before the ECB’s rates had even bottomed out.

That economy-wide strength has translated into dependably positive returns on U.S. investments at a time when benchmark rates in Europe and Japan remain negative. And, somewhat curiously, the dollar has simultaneously weakened against each of those region’s currencies over the last six months, further sweetening the deal for foreign buyers.

At press time, a dollar bought about four-fifths of a euro, down about 14 percent from this time last year. And at the greenback’s high in early March, 2017, one dollar cost about 115 yen. In January of this year, the dollar fell to a discount of about 8 percent off that level, though it has retreaded slightly since then.

That’s a counterintuitive shift that economists like CME Group’s Blu Putnam don’t see a single easy explanation for.

“It is interesting—[former Federal Reserve Chairman] Alan Greenspan would have called it ‘a conundrum,’ ” Putnam said. “You would have expected to see some strengthening in the dollar.” He suggested that foreigners may fear that recent U.S. expansion is accelerating into territory where continued price increases will be fueled by inflation rather than by real growth, somewhat curbing their eagerness to climb aboard.

Or, it could reflect waning confidence in an up cycle going on 10 years old.

“This is approaching the second-longest expansion we’ve ever had,” Putnam noted.

Experts hasten to point out that cross-border investors arbitrage currency imbalances only at their own peril. Money prices evolve in a random walk, they say, making it nearly impossible to time trades like real estate deals to advantageous dips in the value of the target country’s currency.

“If you want an opinion in which direction is the dollar going to go, that’s very, very hard to do,” said Thomas Mertens, an economist at the San Francisco Federal Reserve. “Exchange rates are just inherently hard to forecast.”

Somewhat less opaque are the effects that the real estate world expects from December 2017’s fiscal stimulus—in the form of corporate and individual tax breaks—to have on the business cycle. Seyfarth Shaw’s February survey of more than 150 owners, developers and investors found that 58 percent believed the tax cuts would extend the current cycle for another year or two, while 17 percent more thought the effects would be even longer lasting than that.

“In the general scheme of things … we’re seeing that the cycle should continue through 2019 and 2020 based on the tax act, growth factors [in the United States] and international growth,” said Ron Gart, a partner at Seyfarth Shaw. He added that the investors believe the federal funds rate this year looks likely to hit a sweet spot, rising enough to reassure the market of solid economic growth while keeping financing loose enough for deals to get done.

An enduring role

All those variables combine to bestow upon western gateway cities a comfortable niche within global asset managers’ portfolios, said Ted Willcocks, the global head of real estate asset management for Manulife, the insurer that gobbled up John Hancock Financial in 2004.

“We invest the majority of our funds on behalf of our general accounts, and we need to backstop the liabilities,” Willcocks said. “Real estate is traditionally an alpha to a fixed-income portfolio, meaning it might return 9 percent over 30 years.”

That’s a long-run niche that investing in stable growth markets can fulfill for Manulife with aplomb. Strong fundamentals—not volatile spikes—fit the bill best.

“The economy is rapidly changing throughout the U.S., with a number of cities becoming tech hubs,” Willcocks said. Now, he said, investors are most interested in asking, “ ‘Where’s the talent? Where are the jobs?’ ”

To the extent that New York and San Francisco answer that question more dependably than Durban, the city that MSCI found offered the highest returns, investments in those U.S. cities should remain attractive, even if exposure to income comes with a steeper price of admission.

Granted, MSCI found that over its 10-year horizon, returns in British, American and Irish cities were more volatile than in Asia or Continental Europe, but that statistic may actually mask an indication of strength. Those countries experienced the most severe banking crises in the late 2000s—but also recovered the quickest, leading to higher standard deviations than elsewhere.

The bottom line is that “over the very long term, many investors expect capital appreciation,” Robson said. “If there is a long-term investment horizon, the investors may be less concerned with year-by-year volatility as long as the long-term trajectory still looks good.”