Prime address: the new Dutch headquarters of the Capgemini consultancy was recently sold in Utrecht.
Frits van Dongen / Daria Scagliola / Capgemini

Silent stars

Attractive commercial properties in Europe’s major cities are as rare as they are expensive, prompting more and more investors to switch to secondary cities that offer both opportunities and risks.

The fashion-conscious inhabitants of Hanover have had a new attraction since March 2014. In the spring Peek & Cloppenburg opened its “Weltstadthaus” store with 13,000 square metres of sales space in the city centre. This is part of the new Kröpcke Center, which has been created on the site of the shopping mall of the same name built in 1972 and was purchased by Union Investment in 2013. For Philip La Pierre, Head of Investment Management Europe at Union Investment Real Estate GmbH, the new Kröpcke Center is “a classic example of the successful revitalisation of a long-established high street retailing icon” – and above and beyond that a promising investment in a city which does not rank among the very big property locations. Union Investment’s actions are being mirrored at present by many investors in Germany and other European countries: they are buying shopping centres, office buildings and hotels not only in primary, or Class-A cities, but also in smaller or medium-sized cities.

The increasing willingness to take risks means secondary cities are generating more interest as an investment location
Christian Schulz-Wulkow, partner at EY Real Estate

For example, again in Hanover, the Munich-based Accom Immobilien Holding purchased the Podbi-Park retail and office complex this year. In Manchester the investment management company SWIP acquired the striking Sunlight House office block, whilst in the French city of Lyon BNP Paribas REIM bought the Le Quatuor office building in the district of Gerland. There will be more transactions of this kind to come: in a survey conducted by the EY accounting firm 96 percent of the insurance companies questioned were convinced that demand for properties in secondary, or Class-B cities, will rise further. “With the increasing willingness to take a risk coupled with yield compression in the top seven locations, Class-B cities with a sound business structure are generating more interest as an investment location”, notes Christian Schulz-Wulkow, partner at EY Real Estate. The main reason for this interest is obvious: because the supply of high-quality properties in the top cities is limited and they are correspondingly expensive, investors are seeking alternatives. “The more expensive the Class-A cities, the more investors are looking at Class-B cities”, observes Philip La Pierre. This is confirmed by Jan Dirk Poppinga, Head of Retail Investment at CBRE: “When a capital surplus and product shortage collide, investors are forced to switch.”

What are Class-B cities?

Class-B cities are also known as mediumsized cities or secondary cities. There is no binding definition of a Class-A or Class-B city. The crucial factor is their importance within the national framework. Centralised countries usually have only one Class-A city, namely the capital. Federal states, on the other hand, can accommodate several Class-A cities.

Pros and cons

It is the little siblings of the Class-A cities that benefit from a significant yield advantage: Hela Hinrichs, National Director EMEA (Europe, Middle East, Africa) Research with property consultancy Jones Lang LaSalle (JLL), estimates the top yield for office properties in western European Class-A cities at 4.76 percent; for comparable real estate in Class-B cities a top yield of no less than 5.63 percent can be achieved. According to the laws of the market, however, a higher yield means a higher risk. “Class-B cities have a marketability drawback which as an investor you have to factor into the price”, explains Philip La Pierre. This means, according to Marcus Lemli, CEO Germany and Head of Investment Europe at Savills, that “some properties cannot be sold in difficult market conditions.” A further difficulty in Lemli’s view is the low market transparency of smaller cities, although Class-B cities have their advantages. “Class-B cities are less volatile than Class-A cities”, notes Lemli. “Prices, rents, and initial yields therefore fluctuate to a lesser degree.” This is also linked to the fact that in smaller cities even in an economic upturn there is little speculative buying of office buildings. A further plus point: the competition for attractive buildings is not quite so fierce. “The focus for many investors remains on the major cities”, observes EY expert Christian Schulz-Wulkow.

Very pleasing for Philip La Pierre is that “the pricing reaches a sensible ceiling more quickly.” It is high time that major investors finally recognised the opportunities of Class-B cities, says Lutz Aengevelt, managing partner at the Düsseldorf-based estate agency Aengevelt, which also has a presence in less favoured cities, such as Leipzig and Magdeburg. He believes that focusing on major cities, given Germany’s federalist structure, is wrong: “In reality, Germany’s economic power is displayed in the Class-B cities.” Those who included local know-how would also achieve the desired market transparency, he adds. Günter Vornholz, professor of real estate economics at the EBZ Business School in Bochum, takes a very different view. “The risks of Class-B cities are considerably higher”, he argues. “When the economic boom subsides, the properties there are no longer so sought after, and difficult to sell as a result,” he says, adding that searching for new tenants in smaller locations in a harsh economic climate also posed quite a challenge. The fact that many investors still choose to get involved with Class-B cities can be explained, says Vornholz, by the real estate cycle: once the economic crisis was over, it was the Class-A cities which came to the fore first.

Secondary cities have a marketability drawback which as an investor you have to factor into the price.
Philip La Pierre, Head of Investment Management Europe at Union Investment Real Estate GmbH

As things developed, he says, the investors switched to the Class-B cities because they were willing “to take on more risk for a higher yield.” Vornholz’s recommendation: “Risk-averse investors should stay away from office buildings in Class-B cities – or acquire only the best property in a prime location with the best tenants.” And here the experts once again concur: “It must be the best location in Class-B cities”, stresses Philip La Pierre. Investors should, according to La Pierre, begin by looking more closely at cities which boast a distinguished university and a strong research environment. “Such cities,” notes the investment expert, “promise favourable demographic growth and sustained expansion.” Heidelberg and Freiburg, for instance, would meet those criteria. For Fabian Klein, Head of Investment at CBRE in Germany, the office markets of Wiesbaden and Mannheim also offer great potential. However, in the smaller cities there is one significant problem. “The greatest challenge is finding properties above the €15 to 25 million price range”, says Olaf Janßen, Head of Research at Union Investment Real Estate GmbH. For the retail funds of Union Investment, as well as for many other institutional investors, only purchases from this magnitude upwards apply.

Limited choice

All these trends are not confined to the German market but also to be observed in other European countries – even if to a different extent. “In the UK, London is very dominant, whilst the office markets of all other cities are much, much smaller”, explains JLL researcher Hela Hinrichs. “That increases the risk of not finding new tenants there in a difficult economic climate.” Nevertheless, Jonathan Hull, Managing Director of CBRE’s EMEA Capital Markets, is registering growing interest, above all from US investors, in office properties outside London. This trend is being driven by the economic recovery across the UK. The experts at Savills therefore anticipate falling vacancy rates in the regional office markets. Above all the cities of Manchester, Birmingham, Edinburgh, Glasgow and Bristol are seen as locations with potential – and significant yield benefits: according to Savills, the initial yield for office properties in London’s West End in the first quarter of this year came to 3.25 percent, compared with 5.75 percent in provincial cities.

Even more extreme is the concentration of the office market on the French capital. According to BNP Paribas Real Estate (BNPPRE), cities outside Paris achieved in the first quarter of this year just a 19-percent share of the total transaction volume. The only fairly significant office location in the provinces is Lyon, where last year commercial real estate worth €869 million changed hands. Class-B cities in the Netherlands, on the other hand, are experiencing an upswing. “The prime office investment market in Amsterdam was particularly strong in 2013, however as available supply diminishes, we expect buyers to turn increasingly towards prime assets in the other major cities and non-core offices in the capital”, reports Clive Pritchard, CEO of Savills Netherlands. Amsterdam may have accounted for a good 70 percent of total transaction volume in 2013, but Rotterdam, The Hague and Utrecht also boast an office market to be taken seriously. With the sale of the Capgemini headquarters to AM Real Estate Development, Utrecht even recorded one of the most spectacular transactions in the first six months of 2014. In Belgium, on the other hand, “Brussels remains by far the main favoured area to the investors in the office segment”, reports Pascal Mikse, Head of Research at BNPPRE Belgium. Over the past five years Brussels has accounted for 74 percent of total transactions in the Belgian office space segment.

The situation in Poland is different again. In the capital Warsaw, many new projects are coming onto the market, as a result of which the office vacancy rate is rising. “Many institutional investors are eying opportunities in secondary cities, especially in the retail and office sector”, reports Anna Staniszewska of BNPPRE Poland. “Wroclaw and Krakow are the regional centres which together attract considerable investment”, adds Savills CEO Germany Marcus Lemli. However, the office markets there are very small: Krakow, a city of 750,000, has only 635,000 square metres of modern office space. By comparison, Freiburg, a city of about 200,000, has total office space of 1.3 million square metres. Interest in retail properties outside Warsaw is especially keen, as demonstrated by the spring purchase in Poznan by ECE and Resolution Property of the Poznan City Center, a shopping mall with 58,000 square metres of floor area. Union Investment is also active in medium-sized cities: for UniInstitutional German Real Estate, a fund for professional investors specialising in commercial properties in Germany’s medium-sized cities, the Hamburg-based company recently acquired the Weser Tower in Bremen – further purchases outside Germany’s major cities are set to follow.

Olaf Janßen is the Head of Research at Union Investment Real Estate GmbH, which monitors secondary cities in Europe and beyond.

“A very attractive addition”

Olaf Janßen on the special attraction of secondary cities

Many investors cannot find suitable properties in primary, or Class-A cities, or they have to pay very high prices for them. Is the growing interest in secondary, or Class-B cities, an expression of desperation?Demand for real estate is indeed growing from quarter to quarter. Available properties are rare, especially bearing in mind that new construction activity has been limited in recent years. However, that certainly does not mean that the interest in Class-B cities is an expression of desperation. Rather, it is legitimate in any market where goods are scarce to cast the net wider.

Which specific aspects play a special role when investing in a Class-B city?
The markets there are not as transparent as in Class-A cities, and they are more localised in nature. In addition, the available office space is much more limited. Bearing in mind that the capitalisation factors and top rents are lower as well, investors planning to spend €100 million quickly come up against a limit. Normally Class-B cities are of interest to investors looking to buy properties in the €15 to 50 million range.

Are smaller secondary cities suitable for risk-averse investors at all?
Certainly. Modern office space and attractive shopping malls are also to be found in Class-B cities. In the office segment, the vacancy rate is also lower than in Class-A cities. This is because there are fewer developers operating in the market and the proportion of owner-occupiers is higher. This gives the market a certain level of stability. In boom periods the prices in medium-sized cities rise just as they do in Class-A cities, but less sharply. The market correction which generally follows an economic boom is also more moderate as a rule.

Are properties from secondary cities suitable as an addition to a portfolio?
They are actually very attractive as an addition to a portfolio, because they generally offer higher initial yields. In Britain, the difference is about 200 basis points, and in France 180 basis points. In Germany, the difference between Hamburg and Hanover at the end of last year was roughly 120 basis points.

Is there a danger that investors in the current market cycle are already paying overinflated prices because they have spotted the opportunities offered by Class-B cities too late in the cycle?
Past experience shows that a property cycle in Germany lasts at least seven years. So, we assume that both 2015 and 2016 will be very good property years as well. At the moment the pricing is fundamentally justified. Whether it will still be justified in a different market cycle or a different interest rate environment is difficult to say right now. Basically the following applies: investors who are currently putting their money into either Class-A cities or Class-B cities need, given the backdrop of low yields, rental growth in order to make their investment economically viable.

Is the interest in Class-B cities as great elsewhere in Europe as it is in Germany?
It is particularly marked here because Germany’s economic prospects remain outstanding and because Germany has a big economy with a very diverse range of cities.

And how much are international investors focusing on Germany’s medium-sized cities?
International players who come to Germany do not primarily pursue a Class-B strategy. Those entering a new market go to the big locations first to familiarise themselves with the local conditions. Therefore, the competition among investors in Class-B cities is not as marked as in Class-A cities.

The interview was conducted by Christian Hunziker.


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