The difficulty of talking about secondary cities as an investment category is that they are not really one at all: each secondary city is investible for its own - or its national market's - very specific characteristics. They share only minimal characteristics in common.

It is hard to see what Pozen has in common with Lyon or Hamburg, for instance - other than that none is the capital and all have been the target of recent investor interest.

The one factor European markets with investor appeal do have in common - with the possible exception of Germany - is a formerly more attractive capital that lost its appeal once it became saturated with investor capital. In short, investment in secondary cities is the result of capital overspill.

In the UK, for instance, too much capital chasing too few opportunities will end up in secondary real estate markets such as Reading and Cambridge in 2007, according to PricewaterhouseCoopers (PwC) in its report ‘Emerging Trends in Real Estate Europe 2007', published in co-operation with the Urban Land Institute. Because they are attractive urban markets? Not necessarily. What they are not is London.

"It's a fairly widespread phenomenon," says PwC partner John Forbes. "Over the past four or five years we've seen yield compression across the UK, especially in London. It is reaching the end of the process. Even in London, the plateau the markets have reached is as good as it is going to get.

"There aren't necessarily fewer opportunities outside the capital," he adds. "In the UK, you have London but you also have Glasgow, Edinburgh and Manchester. There are plenty of other cities."

Other cities are what Germany has plenty of. In fact, when it comes to secondary markets, Germany is a special case simply because it has so many of them. According to PwC, secondary cities such as Munich and Hamburg represent a "Teutonic triumph", appearing in the European top 10 for the first time in 2006 (fourth and ninth, respectively).

Almost uniquely on the continent, the chief advantage of these cities is not the fact that they are not Berlin. The investible factors for German pension funds are not necessarily location at all, for instance, but sub-asset class, notably residential. In contrast to other classes noted in a recent report ‘Sireo Research 2007 - Portfolio transactions in Europe', a collaboration of the Centre for European Economic Research and investment managers Sireo based near Frankfurt that mapped real estate transactions since 1997, in Germany alone residential appeared in more than 50% of deals.

Even within this sub-class, property type and age are as significant as location.

"Germany is the most interesting European market in that respect," says Forbes. "[Privatised] public housing is the big thing - but office and retail, too; it's just that residential has been in the headlines." (Compare the positive prognosis for office in Germany's secondary cities with that for Berlin office, where PwC-polled investors identified oversupply.)

An unidentified north German pension fund in February sold a 55-unit residential portfolio to Hamburg property firm Hanseati. For Hanseati, the €4m deal made sense because the block was already fully let, because of the fashionable location (Alsterdorf/Winterhude) and, significantly, because the block was up for sale in a familiar - in fact, home - market for the firm.

Yet Hanseati spokesman Kai Nicolas Andritschke played down the specific appeal of the Hamburg market. What mattered, he said, were the higher returns on 50-year-old residential. He said pension funds would continue to sell 40-50-year-old property portfolios and to chase new ones because they were less dependent than real estate companies on high yields.

"There's no big difference between Hamburg and Munich and Frankfurt," says Andritschke. "The yields on new properties are too small for us. Insurance firms [and pension funds] can live with lower yields."

Given the spread of capital from capitals to secondary cities, it would be easy to lose sight of characteristics other than geography in pension funds' investment decisions. That would be a mistake. The same factors apply, whether in Paris or Preston.

Across the continent, the appeal is as much about the specific characteristics of the market or the asset class as it is about the geography of the conurbation. What you end up with is what might be called incidental investment in secondary cities. Thus, in September, Morley's pooled pension fund acquired an office block in Swansea, Wales's second city, for £16.5m (€24.6m). The deal was notable not just because the block housed the legal practice of one of the country's favourite sons, writer Leo Abse, but because it was an off-market deal that by-passed the difficulties of sourcing value-for-money deals on the public market.

Yet fund manager Richard Peacock claimed the deal was more a result of fluke than strategic investment in secondary cities. "It isn't indicative of a preference for specific cities. It doesn't reflect a particular strategy," he says.

This tells us what, exactly? That fund managers act strategically but think opportunistically? Rather, it suggests that what motivates investors is not where there is traction in geographic terms but where there is a deal to be had in a location not priced beyond all reason.

In France, for instance, retail parks, warehousing and light industrial are almost always outside capitals, though they are often - in contrast to those in central and eastern Europe - in, or close to, major conurbations. It was warehousing that boosted the appeal of French cities Lyon and Lille in May when Arlington acquired the first two assets for its logistics fund for €58m. The €500m fund invests in western and central Europe.

In its state-of-the-continent report, PwC identified Lyon as "an alternative market to the competitive environment in Paris", offering value for money in both office and retail. The consultancy cites prospects for balance between supply and demand that are "better than for most cities", with positive prospects for development.


t is not just individual market and asset characteristics that make for attractive real estate markets. Macro-economic growth helps pull international investors into secondary cities, as they do into capitals. Certainly this is the case in Germany, which accounts for 30% of the Euro-zone's economy, with measured GDP growth last year at 2.5%.

Standard Life says it has no secondary-city strategy but has targeted the recent €17m acquisition of logistics in Neuss, Germany, and retail warehousing in Brno, Czech Republic. Fund manager Will Fulton said that in both cases he expected upward trends in consumption - combined with business confidence in Germany, and expected stronger rents and better value in the Czech Republic - to justify the investment, as well as proximity to major conurbations.

Economic growth has also driven investor interest in Finnish real estate. Swedish real estate investor Sveafastigheter has in recent months been on a spending spree in Finland and has started to move outside the capital Helsinki to secondary and tertiary cities.

It makes sense, says investor relations head Jorgen Osterberg, because the macro-economic growth is, if not equally strong across Finland, strong enough in secondary cities to justify the additional risk. At the same time, price rises in the capital have driven investors into secondary cities in pursuit of effectively the same opportunities, cheaper.

"People are looking outside the main cities," Osterberg says. "They're still looking at office complexes [and retail, as they were in Helsinki] but spreading to other cities. It's not that Helsinki is unattractive," he adds. "But these are good properties in good locations with strong local economies.

"It has been a very local market so far," he says of Finland. "As international investors have become more active, prices have gone up. But outside the capital it's still a very local market. More and more are looking outside Helsinki. That's a natural progression. Prices go up in the capital because that's where all the action is. Then it starts to move outside."

In any case, he points out that Sveafastigheter pursued the same strategy in Sweden, concentrating first on the capital before scouting investments in secondary cities such as Malmö.

It is not just Finland. Where the drivers are macro, not having plenty of other cities has not necessarily damaged the investibility prospects of otherwise attractive real estate markets.

Whether the market has a multiplicity of rivals does not seem to be particularly significant in determining whether secondary cities will prove attractive to investors. Germany, the UK and Spain have; Finland has not.

"Each market is unique," says Forbes. "In Spain, you have Madrid - but also Barcelona. In Italy, Milan is in many respects a more important market than Rome. It's a uniform trend because of the huge weight of capital. The move from capitals to secondary cities is a definite theme."

Investors may bypass the outermost in search of return but how far are they prepared to go? According to Forbes, it may be time to jump off the train and head for the nearest old people's home.

"For higher returns, investors will have to opt for geographic and other diversification," says Forbes. "That includes secondary cities but also less developed countries, such as those in eastern Europe. We're also seeing them looking at less conventional real estate - hotels and nursing homes, for instance - because the more core markets have been swamped with capital.

"It's a manifestation of the same theme that's pushing people to invest in Croatia and hotels - the hunt for more exotic investments."

‘Exotic' here means equally urban regeneration and redevelopment opportunities and Istanbul.

But let us be clear: these are all second choices. Where there is yet some absorptive capacity in primary cities, those are the receptacles for investors' capital.

Thus PwC's report cites Bucharest and Sofia - the capitals of Romania and Bulgaria, respectively, rather than, say, Iasi and Burgas - as the other likely gainers from European real estate trends in 2007. It seems secondary cities are the new eastern Europe: good if you have an appetite for - or need to accept - a bit more risk.

Where next? Tertiary cities are already swallowing the overspill - look at Swansea. But there is a limit, after all. Rather, pension funds will be looking to new deals in new asset classes and - who knows - in new locations.

Property's B-side

t seems there is a hierarchy of secondary cities. PwC's guide to un-central and unlikely bargains cites as factors in investment decisions market cycle and recovery prospects.

Market cycle: Edinburgh

According to investors polled by PwC, Edinburgh appears as a poor also-ran compared with the growth also-rans of Reading and Cambridge. With an increase in office sell recommendations (from 7% in 2006 to 23% in 2007), the city's infrequent mention reflects the fact that the market's real estate cycle has not moved into a confirmed, recognisable, and sustainable recovery phase".

Anticipating recovery: Milan

Optimism for Milan - it ranked second in the PwC index in 2005 - periodically dissipates, with investors looking for increased demand and rent increases: in other words, a sustained recovery. In the meantime, some investors are expecting a rise in the quality of real estate portfolios to attract high-end investors. That just leaves its questionable infrastructure.

Strong centre: Munich

Sustained recovery in the real estate cycle combined with increased office demand, rental growth, a strong city centre, and an educated workforce to propel Munich to fourth among PwC's top 10 cities. Most investors polled gave retail and industrial, as well as office, a ‘buy' rating.

Go shopping: Lyon

Lyon appears as "an alternative market to the competitive environment in Paris" because it is still possible to find value for money there. It beats most European cities - primary or secondary - for office, retail and warehousing.