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One Warning and One Opportunity for Long-Term Investors From the UN Habitat 3 Conference

Caroline Nowacki
Monday, November 21, 2016

The United Nations Conference on Housing and Sustainable Urban Development convenes every two decades to debate human settlement and collectively set goals for our urban future. The third of these conferences, HABITAT III, happened in Quito, Ecuador from Oct. 17th to 20th. After two years of negotiation between countries and preparatory meetings that brought in local governments and civil society, the New Urban Agenda was adopted on Oct. 20th 2016. Municipal Finance was a key topic discussed at HABITAT III. Nations’ foreign ministries, development banks, think tanks and local governments were at the forefront of discussions on how to fund and finance the New Urban Agenda. On the contrary institutional investors were nowhere to be seen, despite the relevance of the topic to their investment portfolios.

Indeed, the share of institutional investors’ portfolio dedicated to real estate and infrastructure has been in constant progression over the past 5 years. JP Morgan forecasts that institutional investors’ average allocation to real assets (Real Estate, Infrastructure, Timber and Farmlands) would soon be around 25% from 5 to 10% in 2015[1]. They also advised investors to look for non-domestic real assets for the low correlation of these assets with stocks and bonds, and between themselves. But investment in real assets in foreign countries comes with hard-to-assess political and governance risks. As the recent example of CETA shows, investors have used contracts and legislations to try to make governments keep their promises over the long run. However, it seems that no elected government could legitimately protect private investors’ returns when their country’s economic development and their population’s purchasing power stagnates or decreases. This begs the question of how to align an investor’s strategy with projects that directly support populations’ increased quality of life, as the best protection against political risks.

On this matter, we can draw one warning and one recommendation from HABITAT III for institutional investors.First, the warning comes from how governments and private investors share the profits coming from land appreciation. Value capture was on everyone’s lips at the conference. However, what value capture means covers a wide gradient. In North-America, it has traditionally been associated with more flexible legislation allowing a negotiation between real estate developers and local government _ for example granting a higher Floor Area Ratio to a real estate developer in exchange for the construction of public infrastructure[2]. This has also been pursued to fund public transportation, in which a large part of the value is captured by real estate development close to new stations.

However, some Latin American countries, and notably Ecuador, have gone further. Ecuador President Rafael Vicente Correa Delgado proposed legislation that would cap the return on investment of land speculators to a certain percentage. Profits over this limit would go to the State. Proposed at 7.5%, this cap seemed aligned with the average return on equity that pension funds claim to target. However, it is lower than real estate investors’ targets, especially when considering risks associated with construction and the institutional maturity of the country.

Two main arguments support this proposal. First, price increase in urban real estate comes from the attractiveness of the urban context: the services and employment opportunities offered in cities and not building itself. Second, taxing land value increase is better for the economy. The International Union for Land Value Taxation argues that countries hurt their economy by taxing labor and production, whereas taxing land price appreciation instead would support the real economy. Of course, that is if pension funds are not counting on double digit returns from real estate investment to be able to pay pensions to retirees.

The bottom line is that with the inscription of the Right to City in the New Urban Agenda, governments are likely to rethink how increase in real estate prices in high-demand urban areas are shared between private investors and governments. This could mean a global reduction in returns from these investments if they are envisioned as pure speculation on land price appreciation. This might be a gloomy picture for traditional real estate investors, but it is also an opportunity for long-term investors who want to add value to the city’s urban fabric. Indeed, the trend is real estate has been to build single-used buildings and gated communities. It makes the design and construction easier, and gives the impression of a reduced risk, by making it fit with existing categories for risk assessment. However, these developments lock in large parcels of land for a single use over decades, when traditional cities have seen uses in one district change significantly and frequently over time to adapt to economic, social and technological changes.

Almost no district in a traditional city has had a single use over time. The Marais in the center of Paris was only recently became a LGBTQ-friendly district with expensive lofts and night-clubs. Only a few decades ago, it was primarily, and still is to a certain extent, the center of the Jewish community, and a clothing manufacturing hub. By retaining aspects and uses from different phases of its history, it is keeping its resilience and increasing its attractiveness. For investors, creating flexibility of uses and allowing for co-existence of activities and population means fostering long-term value and decreasing risk. Some would argue that centrality is key. Sure, Le Marais is also at the center of Paris. But centrality is not enough, or the inner cities in the USA would not have been deserted. Investing in what urbanists call “complexity”: a diverse set of activities and maintaining access to a diverse set of people seem to matter more than centrality.

Preserving flexibility of uses depends on local governments’ regulations but also on investors’ vision and asset classes. Moving away from single use risk pricing and embracing the fact that the city’s positive externalities is based on high correlation between uses is a first step. Long-term investors, notably some sovereign development funds and alternative assets funds, have started to take this stance and have been investing in complementary projects with infrastructure and real estate components. The discussions at Habitat 3 around “right to city” and land value capture will not change regulations and practice overnight. However, long-term investors should not ignore these trends as they show the cracks in the current model, and show the potential for long-term investors to reap the benefits of pioneering new investment models.

I thank the UPS Foundation for their financial support. All opinions and conclusions expressed above reflect the views of the author, and the UPS Foundation should not be held responsible for the views and opinions expressed herein.

Sources

[2] A recent report by the Lincoln Institute on land value capture features the use of special assessments in California as one of the longest value capture experiences in the United States, with the Mello-Roos Act supporting the financing of parks, open space, gymnasiums, swimming pools, landscaping, rail transit, and other public facilities.