THINK Global: Offices

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1 THINK Global: Offices The growth of emerging world cities and potential target markets for institutional investors Data generating art Using data from Fig.6 in this report, the graphic represents potential future office markets. This document is solely for the use of professionals and is not for general public distribution.

2 Introduction Global megatrends are reshaping the world economic order, with rapid economic growth in emerging countries leading to mass urbanisation in cities across Asia, Africa and South America. As these cities undergo a gradual transition from production to consumer industries, and increase their financial and business services, exciting opportunities will arise for global real estate investors. This report describes key features of the shift in economic power from the West, detailing how rapid growth rates in emerging world cities have already created major new office centres in Asia and South America. It goes on to hypothesise how the world order might change further for the global office investor by However, while future growth prospects might appear enticing, a reality check is required. Emerging cities are fraught with unpalatable risks for institutional investors, and a realistic assessment of future market transparency is required. As the report concludes, the combination of market scale and transparency considerations generates a relatively short list of potential target markets, even before other major risk factors are taken into account. Kuala Lumpur s Petrona Towers THINK Global: Offices 3

3 Shift in economic power from West to East We often hear about the shift in economic power from West to East, sometimes rather crudely and unhelpfully interpreted as China s ambition to displace the US as the world s biggest economy. China s rapid growth in recent decades has, however, underpinned the development of much of emerging Asia. Fig.1 illustrates relative shares of world GDP since the turn of the millennium, along with projected shares over the next fifteen years. It shows how the large emerging markets of the East - China and India have gained ground, particularly since 2008 when the US and China experienced contrasting fortunes after the global financial crisis. However, as these projections from Oxford Economics demonstrate, the US is expected to maintain a comfortable lead over China well beyond Fig.1: Share of world GDP in market prices (%) * Key US China India Source: Oxford Economics, August 2015 *US$ constant 2012 prices Beijing 4 THINK Global: Offices

4 Shift in economic power from West to East (continued) One factor that gets overlooked by focusing on absolute economic size is the gap in relative prosperity, measured by GDP per head. However, this measure can conceal big differences in income distribution and economic equality, where there is currently a substantial gulf between developed and emerging world cities. Fig.2 considers all cities with populations that exceed half a million inhabitants, and groups them according to their respective region. Taken together, this sample accounts for around 2.5 billion of the global population, and over half of the world s GDP. The results highlight the envious position enjoyed by North America and Europe, whose combined cities enjoy half of the overall GDP for just 19% of the population. Asian cities, meanwhile, account for 37% of the world GDP and 61% of the population. Emerging Asia (not shown in Fig.2) is even poorer, accounting for 25% of GDP and 56% of the population. The relative affluence of developed cities has persisted since the industrial revolution, when technological innovation and competitive advantage were locked into western economies. Prior to this, China and India constituted the world s biggest economies because population size was the dominant factor in economic output. However, India and China have industrial leverage and are moving up the world rankings. In recent decades, the rapid economic growth in emerging Asia and Latin America has helped to close the relative prosperity gap, a trend that is expected to continue over the next decade. Between 2015 and 2030, Oxford Economics projects Asian cities will benefit from a 90% rise in GDP per head, compared to 35% for North American and European cities. The absolute prosperity gap measured in market prices will remain great, but adjusting for the differences in price levels produces a more meaningful like-for-like comparison of relative prosperity. According to forecasts by Oxford Economics, in purchasing-power terms, the GDP per capita of the average Chinese person is predicted to rise from 25% of the average American today to 37% by Indeed, if we account for the difference in price levels between China and the US, then China is already the world s largest economy, having gained that distinction in Fig.2: Regional share of city GDP and population in 2014 * Key GDP Asia US and Canada Population Europe Latin America Middle East Oceania Africa Source: Oxford Economics, August 2015 *$ constant 2012 prices THINK Global: Offices 5

5 Mass urbanisation and the rise of the East Rapid economic growth is focused on emerging cities, particularly in Asia and Africa, where urbanisation trends are leading to the enormous expansion of existing conurbations, alongside growth in new cities. Fig.3 shows the league table of the world s 25 most populous cities, ranked by projected population size in 2030 vs By 2030, only five developed cities are expected to remain on the list, and most will have lost relative ground compared with their ranking today. Lagos and Kinshasa in Africa are expected to see the largest change in their relative position, while Jakarta will displace Tokyo as the world s largest metro, with a projected population close to 40 million, around five times the size of Greater London today. The rates at which individual cities mature economically will vary and some emerging cities will outgrow their developed counterparts. A swathe of Chinese cities, along with Bangkok in Thailand, will outgrow Munich, Stockholm, Madrid, Milan and Rome, in terms of economic size. By 2030, Shanghai will almost catch up with Paris, currently the world s fourth-largest metro area. Despite experiencing healthy GDP growth, London will also look nervously over its shoulder as Shanghai and Beijing approach. Fig.3: Top 25 cities ranked by population size in 2030 vs 2014 Rank (2030) Rank (2014) City Population Rank (2030) Rank (2014) City Population 1 2 Jakarta 39, Tokyo 37, Chongqing 33, Shanghai 28, Beijing 26, Dhaka 24, Mumbai 24, Delhi 23, Lagos 23, Mexico City 22, Karachi 22, São Paulo 21, Kinshasa 21, Tianjin 20, Bangkok 18, Osaka 18, London 17, Istanbul 16, Manila 16, Kolkata 16, Cairo 15, Buenos Aires 15, Guangzhou 14, Chengdu 14, New York 21,955 Source: Oxford Economics, August 2015 Key Key Europe Ranking increased by >20 Asia Ranking increased by North America Ranking increased by 0 10 Latin America Africa 6 THINK Global: Offices Ranking remains unchanged Ranking decreased by 0 10 Ranking decreased by Shanghai

6 New office centres on the world map Rapid urbanisation will be accompanied by major new job creation and rising prosperity, particularly for those cities that are able to make the transition to higher economic value services. Fig.4 shows the leading 25 world cities for the creation of new office jobs between 2014 and London and Istanbul represent the only non-asian cities on the list, with Paris Metro in 29th spot. Beijing easily trumps the rest, and Oxford Economics predicts a further three million office jobs will be created over the next fifteen years. This does not mean developed office centres are going to vanish from the list of the top office locations. Many have enormous scale and enjoy major competitive advantage. London, Tokyo, New York and Paris are still expected to grace the world s top 10 markets in terms of office workforce, even by Other developed markets should also retain a place among the top 25, namely Chicago, Los Angeles, Washington and Dallas in the US, Seoul and Singapore in Asia, and Moscow in Europe. Most office markets in developed world cities will lose relative ground. In all, seven Chinese cities will appear among the world s top 25, with Beijing and Chongqing being the two largest. Mumbai and Delhi also make the top 10 and, outside of emerging Asia, São Paulo, Rio de Janeiro and Mexico City also make the cut. Fig.4: Top 25 markets for office job creation Beijing Chongqing Delhi Mumbai Shanghai Hangzhou, Zhejiang Shenzhen Guangzhou, Guangdong Jakarta London São Paulo Ho Chi Minh City Bangalore Ningbo, Zhejiang Lagos Hà Noi Manila Wenzhou, Zhejiang Kolkata Singapore Tianjin Jinhua, Zhejiang Kuala Lumpur Istanbul ,000 1,500 2,000 2,500 3,000 Source: Oxford Economics, August 2015 London THINK Global: Offices 7

7 Potential targets for the institutional real estate investor At present, the desire of institutional investors to access real estate opportunities in emerging world centres is curbed by their lack of transparency and other significant barriers to entry. JLL s global real estate Transparency Index quantifies real estate market transparency to help investors and occupiers understand the critical differences when transacting, owning and operating in foreign markets. Their latest survey, published in 2014, considers 115 factors across the broad categories of performance measurement; market fundamentals; the governance of listed vehicles; regulatory and legal framework; and the transactions process. Comparisons with earlier surveys reveal improvements in transparency ratings in a number of countries. Poland and Spain are ready targets for overseas institutional investors today, but they featured low down on the relative transparency spectrum only fifteen years ago. According to JLL, the forces moving global real estate markets towards greater transparency will remain strong in coming years, and governments in emerging countries will increasingly pay greater attention to regulatory enforcement and anticorruption. Meanwhile, open data policies, aided by technological advances, and the introduction of REITs, will also boost transparency. Three factors are relevant when shortlisting emerging target office markets for potential future investment: (i) Scale This is the current size of the market, defined as the number of employees in the financial and business services sector. We assume a minimum of 200,000 jobs today would provide adequate scale. Our analysis aims to shortlist emerging market targets, but if this criteria was applied to developing world cities, half of all North American cities would fail to qualify, and only 32 European cities would make the cut. Scale is defined by the number of employees in the financial and business services sector (ii) Growth potential This is measured by growth in a city s office-based workforce, based on forecasts from Oxford Economics over the period 2014 to This provides a good indication of an emerging city s potential to continue its transition to a higher value-add economy and, in doing so, create new office districts and open up investment opportunities. Growth potential indicates whether a city will become a higher value-add economy (iii) Transparency potential This employs the current transparency rating of the real estate market or country, based on JLL s index in The analysis includes all countries that are rated as highly transparent, transparent or semi-transparent, as of Semi-transparent markets are included on the assumption they will improve over the next decade or so, making them more appealing to investors. However, the analysis splits the semi-transparent category into leading and lagging semi-transparent markets, and omits the laggards from the resulting shortlist. This effectively excludes Tier 2 cities in India, China and Brazil. JLL have previously reported a widening gap in transparency between Tier 1 and lower tier cities in the BRIC countries. Cities in the lagging category may be considerations on an even longer time horizon. Tier 2 cities in India, China and Brazil are excluded from the transparency potential shortlist 8 THINK Global: Offices

8 Potential targets for the institutional real estate investor (continued) Applying the criteria produces a shortlist of 20 potential targets, presented in Fig.5, and ranks them according to their composite JLL transparency rating in With the exception of South Africa s cities, which are even more transparent than a number of Western European countries such as Portugal, Italy and Austria, the remaining African office markets are excluded on transparency grounds. In Africa, the shift to higher value-add economic structures is likely to be slower than in Asia, and only seven of 93 cities had workforces that exceeded 200,000 employees in financial and business services in Botswana and Kenya qualify for the lagging semi-transparent category, so are arguably the ones to monitor in Africa. Regardless, neither Gabarone or Nairobi have developed office centres today, so both cities are excluded on the grounds of scale. Just three Middle Eastern cities, from a total of 66, have an office workforce in excess of 200,000 Tehran, Tel Aviv and Baghdad with Israel alone classed in the leading semi-transparent category. Therefore, the majority of qualifying office centres are in emerging Asia and Latin America. Fig.5: Shortlist of future office market targets in the emerging world Office jobs in 2014 (000s) JLL transparency score Office jobs % p.a. change Cape Town South Africa Johannesburg South Africa Kuala Lumpur Malaysia São Paulo Brazil - Tier Rio De Janeiro Brazil - Tier Taipei Taiwan Tel Aviv Israel Beijing China - Tier Shanghai China - Tier Shenzhen China - Tier Guangzhou China - Tier Bangkok Thailand Manila Philippines Jakarta Indonesia Mumbai India - Tier Delhi India - Tier Bangalore India - Tier Chennai India - Tier Mexico City Mexico Monterrey Mexico Source: Selected cities by TH Real Estate as at August 2015, Oxford Economics as at August 2015, JLL Transparency Index as at 2014 THINK Global: Offices 9

9 Potential targets for the institutional real estate investor (continued) The top five cities that are classed as transparent by JLL are Cape Town and Johannesburg in Africa, Kuala Lumpur in Asia, and São Paulo and Rio de Janeiro in Latin America. These are the only qualifying cities currently classed as transparent and possessing scale. Of these, the two Brazilian Tier 1 cities have the lowest growth potential and biggest scale. According to JLL, Brazil has made progress in improving the transparency of its regulatory and legal system, and transaction process. While many Latin American markets have no private real estate indices and lack private institutional ownership of commercial property, Brazil launched a private real estate index in Other qualifying office markets that share the leading semitransparent category include Bangkok, Manila, Jakarta, India s Tier 1 metros, and Mexico City and Monterrey in Mexico. Real estate capital market liquidity has produced greater transparency in Mexico with respect to its immature REIT and private domestic pension fund investment markets. India, however, scores poorly in terms of the transparency of its transaction process, and also suffers from high investment transaction costs and low professional standards among local agents. In the emerging world, Kuala Lumpur, São Paulo and Rio de Janeiro are among the top five most transparent cities Fig.6: Potential future target office markets (circle represents size of office workforce in 2014) Of the remaining fifteen markets classed as leading semitransparent, only Taiwan and Tel Aviv represent the developed world outside of North America, Europe and Oceania. From the emerging world, China s four Tier 1 markets offer significant scale and healthy growth potential. At present, China has over 150 cities with a population exceeding 500,000, yet only twenty have an office workforce exceeding 200,000. China improved its transparency rating during the global financial crisis, but progress has been slow in recent years. According to JLL, steady progress has been made on the regulatory and legal fronts, and China performs relatively well in terms of investment performance measurement and market fundamentals. However, transparency of the transaction process remains poor, and progress on structural reform and regulatory enforcement is limited to the Tier 1 cities. Annualised growth in office jobs, Cape Town Johannesburg Kuala Lumpur São Paulo Rio de Janeiro Shenzhen Guangzhou Beijing Shanghai Bangkok Tapei Manilla Delhi Bangalore Mumbai Chennai Jakarta Monterrey Mexico City Transparency: Low score = Good, High score = Poor Source: Oxford Economics as at August 2015, JLL Transparency Index as at THINK Global: Offices

10 Reality check: Investment horizons depend on multiple criteria While JLL transparency data acts as a useful indicator, even a leading semi-transparent score today reflects significant barriers for institutional investors. Transparency is one of many relevant real estate risk factors that must be taken into consideration. Liquidity, income security, and cyclical volatility are pertinent considerations, as are wider economic, environmental and political factors at the national level, such as the general rule of law, incidence of corruption, sovereign credit-worthiness and climate change. Investing in China Tier 1 office markets today would require a significant leap in risk appetite by an overseas institutional investor. Aside from economic and political risk, the hurdles in accessing the market can be significant, which explains why combined investment flows from the US and Europe have constituted just 10% of overseas transactions into China over the past decade. One of the many hurdles is access to core stock, given high levels of owner occupation in the office sector, and fierce competition from domestic players when product does become available. Meanwhile, income risk is compromised by short leases and potential over-development, while uncertainty regarding future land use rights can seem an insurmountable hurdle. Extensive and ongoing country and real estate market due diligence is essential for all suggested long-run target markets. In the meantime, core investors will focus on traditional office centres in the developed world cities of North America, Europe and Oceania, especially those centres with high liquidity and where risk-adjusted returns are both easier to quantify and are better understood. 475 Fifth Avenue, New York, US THINK Global: Offices 11

11 Contact us Andy Schofield Director of Research T: E: This document is intended solely for the use of professionals and is not for general public distribution. Any assumptions made or opinions expressed are as of the dates specified or if none at the document date and may change as subsequent conditions vary. In particular, the document has been prepared by reference to current tax and legal considerations that may alter in the future. The document may contain forward-looking information or estimates that are not purely historical in nature. Such information may include, among other things, illustrative projections and forecasts. There is no guarantee that any projections or forecasts made will come to pass. International investing involves risks, including risks related to foreign currency, limited liquidity particularly where the underlying asset comprises real estate, less government regulation in some jurisdictions, and the possibility of substantial volatility due to adverse political, economic or other developments. Past performance is no guarantee of future performance. The value of investments and the income from them may go down as well as up and are not guaranteed. Rates of exchange may cause the value of investments to go up or down. Any favourable tax treatment is subject to government legislation and as such may not be maintained. The valuation of property is generally a matter of valuer s opinion rather than fact. The amount raised when a property is sold may be less than the valuation. Nothing in this document is intended or should be construed as advice. The document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment. TH Real Estate is a name under which Henderson Real Estate Asset Management Limited provides investment products and services. Issued by Henderson Real Estate Asset Management Limited (reg. no ), (incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3BN) which is authorised and regulated by the Financial Conduct Authority to provide investment products and services. Telephone calls may be recorded and monitored. COMP Designed by Saentys +44 (0) I info@saentys.com