Secondary cities: underappreciated markets for residential mixed-use developments
Everyone in the industry is familiar with the distinct characteristics of the two primary real estate categories, residential and commercial. While residential real estate fulfils a basic need and generates reliable, albeit conservative, returns, commercial real estate is more susceptible to economic fluctuations but provides higher returns. Residential properties have therefore always had a stabilising effect on institutional investors’ portfolios.
Residential properties can be integrated in two ways:
Firstly, they can be included as an ‘admixture’ in a fund via the acquisition of one or more purely residential buildings or a mixed-use building. Secondly, residential properties can also have a stabilising effect within a single property – as is the case with the aforementioned mixed-use, residential/commercial properties. This model has been a defining feature of typical Central European cities for centuries, with retail, crafts, or gastronomy on the ground floor and residential units above, sometimes with storage, production, or offices in between.
A whole neighbourhood under a single roof
This concept finds its urban nucleus in the Gründerzeit districts that are just as popular and desirable places to live in today as when they were first developed 120-150 or so years ago. The high quality of life experienced in these areas, from Prenzlauer Berg in Berlin to Lehel in Munich and Nordend in Frankfurt, is testament to the enduring appeal of these neighbourhoods. Having buildings that offer a combination of commercial and residential space under the same roof helps create vibrant neighbourhoods with convenient amenities and contributes to the stability of the local real estate market. Investors who take advantage of this configuration stand to benefit from a granular tenant structure and more balanced risk profile.
While this approach may seem tailored exclusively to major cities, this is by no means the case. It is not just the Top Seven cities in Germany that offer potential for mixed-use buildings in urban locations. Many B, C, and even D cities also have streets that present viable opportunities for investment in mixed-use buildings. In addition to structural conditions and micro-location, the local infrastructure also plays a decisive role.
More than just the major cities
After all, compared to many other European countries, Germany is highly decentralised, with numerous major metropolitan areas and strong regional centres. While Germany’s Top Seven cities have a combined population of around ten million, secondary cities such as Bremen, Hanover, Bonn, Essen, Mannheim, and Nuremberg also boast significant populations and strong economies.
The same applies to C cities such as Darmstadt, Mainz and Offenbach, as well as to a number of medium-sized cities. These urban centres offer a high quality of life and diverse economic opportunities that are often overlooked by institutional investors, even though they are ideally suited for mixed-use investments. The frequently more attractive price-performance ratios – and thus higher yield potentials – further underscore the advantages of investing in smaller cities, which are largely exempt from the bidding wars of large and international investors in the A cities.
Markets in B and C cities are less liquid – which is also an asset
Many investors have been discouraged by the lower liquidity of real estate markets in B and C cities. However, what may initially appear a disadvantage is, on closer inspection, actually an opportunity: The stability of peripheral markets serves as a deterrent to speculative investors looking for a quick exit after a couple of years, without any major property management effort. Instead, the lower liquidity attracts investors with long-term investment horizons, leading to more stable and less volatile real estate markets. As a result, the price surges common in A cities during economic upswings are far less likely in these secondary cities. When it comes to selecting locations, investors should take off their blinkers if they want to capitalize on Germany’s polycentric regional structure.
Adding residential space to commercial real estate portfolios through urban mixed-use developments in lesser-known markets is a prudent strategy to diversify portfolios and ensure consistent long-term returns. Investors who seriously consider the entire German real estate market, rather than focusing solely on A cities, stand to benefit from these diverse opportunities to add a ‘pinch’ of residential to their portfolios. And institutional investors, many of whom have failed to adequately diversify their portfolios by focusing exclusively on commercial real estate in A cities, would be well advised to do the same and position themselves for both the next real estate boom and the next real estate slump.