Today, 54% of the world’s population lives in cities, and increasing urbanisation means that this figure is only likely to rise. Traditional megacities such as New York, London, Tokyo and Hong Kong have always been targets for investment, but the more savvy investors are increasingly looking beyond these behemoths.

As the more renowned metropolises become oversaturated, causing labour and land costs to rise, investors are looking elsewhere for greater returns. The relative affordability and often-superior quality of life offered by second- and third-tier cities – along with what is usually a less congested infrastructure – is making these destinations increasingly attractive to investors who want to be based in a city but are looking to escape the problems that can come in metropolises. 

The emergence of second- and third-tier cities as a driver of economic growth is a relatively recent phenomenon. In the years before the global financial crisis, a mere 30 cities accounted for 50% of all global property investment. However, strong economic fundamentals, positive demographic trends and a higher quality of life relative to top-tier cities is creating shift in perception, according to Paul Philipp Hermann, co-founder and managing director at online property portal Lamudi Global. “These cities have large, young working populations, [who are] not only contributing more to the economy through their employment, but spending more on consumer goods,” he says.

“The focus is shifting from the classic OECD-type cities increasingly to the emerging world,” adds Richard Yorke, the head of research at commercial real estate firm DTZ. “Increasingly, more GDP is being driven by those second- and third-tier cities. Population and GDP growth per capita is very interesting for businesses as it creates new consumer markets globally and new sources of human capital and expertise.”

Value for money

Coming with these favourable demographic trends and strong economic growth is the relatively low costs in these cities. “It’s all about cost,” says Mr Yorke. “Relative cost and relative productivity are big factors,” he argues, adding that emerging second- and third-tier cities often provide an appealing combination of low costs and high productivity. Because of this, Mr Yorke predicts that in the next few decades, “emerging market cities are going to account for about 50% of [global] GDP growth”.

Despite such predictions, smaller emerging cities do face a number of challenges when it comes to competing with their larger counterparts. Mr Hermann identifies their generally less advanced physical infrastructure, their lower levels of skilled labour, their generally being off the radar, and their higher risk potential as primary deterrents to investors.

An example of these problems is shown in the rapid move of business process outsourcing services to India’s second- and third-tier cities, which were followed by “a degree of retreat to the top-tier cities, partly because it was very difficult for corporates to get the quality of talent in these lower tier cities,” says Jeremy Kelly, a director of global research programmes for advisory firm JLL. “Investing in emerging cities might be cheap, but there is a reason it’s cheap,” he adds.

Rosemary Feenan, a director of global research at JLL, believes that these challenges can be overcome through sufficiently dedicated and market-savvy city management. In order to compete with larger cities, says Ms Feenan, smaller cities must promote their competitive advantage in the provision of goods and services – often technology – and market themselves as cheap and efficient alternatives in those fields. She also emphasises the importance of good governance in mitigating risk potential.

Ms Feenan argues that the most successful second- and third-tier cities are “moving from strength to strength and really understanding what those professional needs are, from a governance perspective in particular”. Brisbane (Australia), Calgary (Canada), Manchester (the UK) and Austin (the US) stand out as success stories, while Shenzhen (China), Nanjing (China), Santiago (Chile) and Nairobi (Kenya) are being recognised by investors for their development efforts – especially when it comes to technology – in the emerging world.

Punching above their weight

“Austin was nowhere 20 years or so ago,” says Ms Feenan. “[The city] made a specific bid to draw in young talent by creating affordable housing for students, by creating a jazz and music scene, by making the city attractive and accessible. That’s the kind of competitiveness that makes business successful and in the end draws in investment.”

Austin experienced the US's biggest increase in domestic migration between 2010 and 2013 – at more than 5% (in the same period, New York’s domestic migration decreased by 2%). Phoenix, Denver and Seattle are other secondary cities noted as growing US hubs for human talent and quality of life, while in 2014 Omaha in Nebraska was awarded the title of best city in the US to launch a technology company by financial advisory SmartAsset.

Brisbane and Manchester both stand out for successfully crafting, promoting and maintaining a brand designed to attract investment. “Last year [Brisbane] hosted the G20 meeting, and called itself the 'New World City',” says Ms Feenan. Brisbane's branding played on the qualities and attributes that have made it desirable to investors – sustainability, talent, transparency, confidence and good governance.

Ms Feenan argues that if a medium-sized city is able to highlight its strengths through effective branding, then “there is no reason why it can’t be very visible on the world stage [or] be a centre of world trade”. Manchester, which Ms Feenan considers the “standout example of a smaller city punching above its weight”, was able to recover from the terrorist bombings of its city centre in the mid-1990s by aggressively pursuing partnerships with Chinese firms, highlighting its strong technical colleges and technology sector, and by branding itself based on these strengths.

Emerging contenders

In China, second- and third-tier cities present enormous opportunities for investors simply because many 'small' cities in the country are substantially larger than most Western capitals. These Chinese cities have an enormous consumer base, increasing median wages allowing for greater consumption, brand new physical infrastructure, and cheap labour. Moreover, because they are considered second- and third-tier cities within the Chinese market, investment premiums are relatively low.

Government restrictions on FDI, the manipulation of its currency, and a penchant for nationalising private industry can make investment in China a risky endeavour, but the significant potential of its emerging cities should not be ignored.

Certain Chinese cities stand out above the rest. Chengdu is “now considered to be the main hub for western China”, according to Mr Kelly at JLL, due in large part to its technology expertise and its ability to attract multinational technology firms, including Intel. Wuhan, considered the capital of central China, is another promising city that Mr Kelly notes is “strong on optics and car manufacturing” and has attracted significant attention from French corporate investors. Xian, the ancient Chinese capital and home of the Terracotta Warriors sculptures, is rapidly emerging as an R&D hub and developing consumer city. Finally, Hangzhou, near Shanghai on the country's east coast, is emerging as another tech hub, and home to e-commerce giant Alibaba.

Beyond China

Growing investment potential when it comes to second- and third-tier cities is by no means limited to China, however, in emerging markets. Nigeria receives the greatest level of FDI in Africa, and while its biggest city, Lagos, accounts for more than 40% of the country’s property market, high prices are encouraging commercial and property investors to look further afield. Notable projects in the country include the 11,000-square-metre Port Harcourt Mall development in Port Harcourt, which has a population 700,000, and the 15,000-square-metre Delta City Mall in Effurun, a city with a population of just over 300,000. Abuja, Ibadan and Kano are also proving to be increasingly attractive destination cities for manufacturing, retail and natural resources investment, with the biggest deals coming from the US, South Africa and China.

Over in Asia, Bangladesh’s second largest city, Chittagong, is a growing hub for financial services, industry and manufacturing. Mr Hermann at Lamudi Global notes that Chittagong’s growing middle class “is also contributing to the development of the city, with the population expected to grow by almost 50% by 2025”. Makati City in the Philippines, with a population just over 500,000 and home to the country’s largest banks and highest concentration of multinationals, is positioning itself for huge growth with a number of real estate projects in the works. Mr Hermann highlights the 21-hectare Circuit Makati on the site of the former Santa Ana Race Track and the 11,000 residential condo units, in addition to office, retail, and entertainment components, planned by Ayala subsidiary Alveo Land, as being particularly noteworthy.

Surabaya in Indonesia – which has a population of 2.7 million, considered small in a country of 250 million inhabitants – boasts economic growth of 7.6%, a strong retail sector, and rapidly developing infrastructure, making it increasingly attractive for foreign companies. According to a report by Lamudi Global: “The local government is working to connect the east and west of the city to attract foreign investment and encourage businesses to take advantage of the city’s growing office space.”

As with all investment opportunities, when it comes to second- and third-tier cities, identifying and acting upon their potential while land, real estate and labour is still relatively cheap is the key. The wise investor will be on the lookout for cities with favourable demographics, strong economic fundamentals and a niche market in which it has a competitive advantage. Significant inward investment in physical and human capital and a concerted effort to promote a city-wide brand are also signs that a second- or third-tier city might be ready to emerge as a driver of global growth.