Selecting the right markets has always been a key element of success for commercial real estate investors, but today it may be more important than ever. The days of rapid price growth seem to be over, which means that returns will be driven by property performance as opposed to appreciation and capitalization rate compression.
What’s more, demand drivers are evolving. Both businesses and workers are increasingly mobile, and are eager to locate in areas that meet their specific requirements.
As a result, investors need to have a prudent strategy for picking markets and a strong view of where we are in the cycle. Without those elements, picking assets is little more than throwing darts at a board. The right strategy involves finding properties that will have lasting demand by virtue of their location and how they meet the needs of users.
Evolving fundamentals
Commercial real estate historically has been neatly divided into ‘primary,’ ‘secondary’ and ‘tertiary’ markets for investment purposes. Large investors such as institutional money managers, REITs and (when market conditions prevail) sovereign wealth funds dominate primary markets such as New York, San Francisco and Washington, DC. Those markets contain trophy assets and are generally thought to be less risky because demand tends to be stable in bad economies as well as good. Secondary and tertiary markets have higher yields, in part because demand is more volatile depending on economic conditions.
The way real estate is occupied, however, is undergoing a wholesale change as a result of technological and social trends. One such change is due to the fact that individuals are much more mobile than ever before. Rather than look for jobs where they grow up, many millennials locate in centers where they want to be. This trend can be overstated—certainly not every 20-something yearns for a hipster lifestyle—but in a generation of 80 million, it is enough to boost population in lifestyle centers such as Austin, Brooklyn, Portland and Denver.
The radical evolvement of mobility extends to companies, as well. Years ago, the typical company may have located where its executives wanted to live, but today an increasing number of firms are setting up shop in places where workers want to be. Hence the growth of metros that provide the type of services and amenities that are attractive to young workers, such as public transportation (millennials drive less than older generations), entertainment and restaurants, and public parks. Technology firms that find Silicon Valley too expensive are setting up in diverse locations that range from Austin to Birmingham, Alabama.
The rise of Internet commerce means consumers don’t need to drive to shopping centers—at least as much. To cater to the urban population, infill retail locations are on the rise, and large retailers such as Amazon and Wal-Mart are building and occupying tens of millions of square feet of distribution space near population centers. While supply of retail space has largely stalled, especially in overbuilt suburbs, demand for newer warehouses with modern technology is on the rise.
How to select?
The upshot for real estate investors is that—much as Moneyball transformed baseball scouting—investors need new ways of analyzing metros that are more sophisticated than the same simple prisms that were used in decades past. So what should investors be looking for? We suggest these metrics:
The first is intellectual nodes. Technology has increased the rate at which drivers change economies. America has gone through eras dominated by agriculture, manufacturing and services, but going forward growth will be fueled more and more by intellectual capital.
We can see this today as growth is thriving in metros including Boston, Raleigh-Durham, Silicon Valley and Atlanta that produce large numbers of highly skilled college graduates. Not only that, but investors need to drill down to submarkets that attract these highly educated workers, either because they contain colleges or because they house businesses that employ skilled workers.
The second is lifestyle centers. As mentioned before, highly skilled and highly paid workers are attracted to areas that are highly livable. Not that long ago, many people thought of urban areas as dirty, crime-ridden and lacking in interesting things to do. However, many urban centers are undergoing a decades-long transformation. Crime has generally fallen, governments are developing parks and green space for entertainment, and public-private partnerships are creating business and retail districts that are attractive and contribute to the 24/7 lifestyle.
Many suburbs, particularly ‘inner-ring’ areas that are just outside cities, have taken to imitating urban areas by developing sections with mixed-uses including residential, shopping and office.
Certainly, livability remains a work in progress in many metros. Education is still a sticking point. Cities will have a difficult time retaining high-earner Millennials if elementary- and secondary-level schools do not improve.
The third is supply. Past real estate downturns were often the result of oversupply, but that doesn’t appear to be a major problem in the current cycle. In the wake of the global financial crisis, banks have become more cautious, while onerous regulations make construction lending more difficult and expensive. That said, development has picked up in some property types (particularly multifamily and industrial) in select metros, and investors should be careful to avoid those spots.
Values flattening
That may be all well and good, but what about the cycle? After several years of a strong run-up in values, commercial real estate prices have shown signs of stagnating in recent months. Major property indexes, including the Moody’s/Real Capital Analytics Commercial Property Price Index (CPPI) and Green Street Advisors Commercial Property Price Index, have fallen slightly in recent months after a seven-year run that pushed values to all-time highs. Likewise, property yields (capitalization rates) have flattened after falling to record lows.
Rather than being temporary, the slowdown in values is likely to linger. Demand for commercial real estate—the so-called ‘wall of capital’—led the sector out of the last recession, but investors are becoming less aggressive as they worry that the market is at peak pricing and they don’t want to be overexposed at the peak again. Meanwhile, the economic engine seems to be cooling down and the industry faces headwinds including widening bond spreads and the growing impact of regulations.
However, there are also some important caveats. Absolute prices may be high, but the premium over the risk-free rate remains consistent with historical norms as opposed to periods of aggressive pricing. Total mortgage volume is at record levels and growing, but leverage on individual properties is not nearly as aggressive as it was at the peak of the last cycle. Even though there is volatility in the capital markets, the last crisis was precipitated by unprecedented growth in leverage of financial institutions. Whatever one thinks of the impact of regulations, they have had the effect of reducing risk and leverage in the financial system.
So while it appears that the rapid expansion in commercial real estate could be exhausted and the market is likely to see a pause in the rapid growth in pricing and deal flow, it’s also hard to see what would cause the kind of deep meltdown we saw in the last cycle. In 2007, transactions were priced with little room for error. Today, leverage is more moderate and development is largely limited (with a handful of exceptions) to markets with strong demand, so a downturn in the near future is likely to be more shallow than others in recent memory.
Bottom line
Today’s market is fraught with complexity. The US economy is increasingly dependent on global sentiment, demand drivers for each property type are evolving as a result of demographics and technology, and a number of metrics indicate that prices have peaked. None of those factors, however, should scare investors from solid investments if they focus on a strategy that enables them to find assets with enduring demand in the best submarkets.
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