‘It Just Sounds Good’: Why Some Investors Ignore The Data And Stick To The Priciest Markets
Population and economic rankings don’t always dictate a city’s business climate. But for many leading developers and investors in commercial real estate, rankings mean everything.
REITs like Federal Realty Investment Trust, Kimco Realty Corp. and Chatham Lodging Trust and investors like Blackstone commonly reference, either on their calls with investors and analysts or in marketing materials, how they operate or deploy capital almost exclusively in top-tier or gateway markets.
“There’s a huge herd mentality to stay in specific markets and on-brand,” said Jacob Reiter, president of real estate private equity firm Verde Capital. “It just sounds good. Who doesn’t want to be in the top 10?”
For Federal Realty, it is an exclusive list of eight: Washington, D.C., Philadelphia, New York City, Boston, Miami, Chicago, Los Angeles and the Bay Area. CBRE caps the number of global gateway cities in the U.S. at six, placing Miami and Philly on a lower tier.
Chatham Lodging focuses on the 25 largest metropolitan areas where the customer base is concentrated around high employment and demand growth, company CEO and President Jeffrey Fisher has said on multiple earnings calls. Kimco CEO Conor Flynn said the current shopping center environment is “supported by favorable supply and demand dynamics in the top 20 markets” on his company’s quarterly earnings call this month.
These firms may have differing stances on what is deemed a top-tier market, but that doesn’t mean every investor is budging in where they are willing to deploy capital — even if a smaller, secondary market may have more opportunities.
“It would take convincing for me to raise capital to do a deal in a place like Cleveland. I’d have an easier pitch if I do Los Angeles. I just would. It’s perception,” said Eric Sussman, a founding partner at Los Angeles-based Clear Capital LLC, where he oversees the firm’s capital, equity and debt departments. “I may well know the upside is better in Cleveland, but some investors are going to say no to investing in tertiary or secondary markets.”
Tampa, Indianapolis, Cleveland, Cincinnati, Columbus, Ohio, and Nashville, respectively, fall just outside the top 25 U.S. markets ranked by overall economic output. Many of these cities have performed well this cycle.
It would be hard to find anyone in commercial real estate who would say Nashville, which got a 5,000-job consolation prize from Amazon’s HQ2 search, is struggling to find developer interest. Financial giant AllianceBernstein is also planning on moving more than 1,000 jobs to the Music City from its longtime headquarters in Manhattan.
Sussman recognizes Cleveland’s housing market has a better outlook than LA’s: Ohio's second-biggest city ranked fourth in a September Redfin report of housing markets least likely to be negatively affected by the next downturn. Los Angeles came in eighth on that list of markets most likely to be negatively impacted.
There is no economic cliff between city 25, Pittsburgh, and No. 26, Tampa. There was about a $1B difference between the two cities’ economies, compared to a $364B difference between Los Angeles and Chicago (ranked second and third, respectively), according to the U.S. Bureau of Economic Analysis.
“When I think of these top 20 lists, I have difficulty with them because it changes so much by industry,” Savills Managing Director Kevin Kelly said. “The cost structure of the markets is so different you can argue cities 11 and 21 are going to have more in common than cities 6 and 11.”
Similarly, the biggest gap in real estate sales came toward the top of the rankings. There was a nearly $29B difference in total acquisition volume over the last eight quarters between New York and Los Angeles, according to CBRE. There was a little more than a $1B difference between Baltimore and San Antonio, which were ranked 25th and 26th, respectively, in terms of acquisition value.
While a buyer may want a higher capitalization rate because it signals a lower sale price, a seller will want a lower cap rate. A CBRE cap rate survey for the first half of 2019 shows central business district cap rate spreads between primary and secondary markets are the tightest seen since the second half of 2014, signaling only slightly better returns in primary markets.
Plenty of secondary markets like Nashville and Austin have boomed this cycle, especially as companies look for lower-cost environments in which to do business away from coastal cities. But many CRE companies and their investors continue to focus their money exclusively on the traditional powerhouse cities.
“Part of what makes those cities attractive to people moving there, but less attractive to us, is you don’t have the barriers to entry,” Federal Realty Investment Trust Senior Vice President James Milam said. “What happens in secondary markets is, as capital starts to move out, you get capital chasing capital and pricing compresses and, suddenly, you’re not getting the return you think you should get from a riskier market.”
Federal commits to its eight markets because their population density, higher incomes and high barrier to entry is ideal for retail, as well as other sectors in the firm’s mixed-use projects, Milam said. Secondary markets may present a greater upside to investors, but their lower barrier to entry runs the risk of oversupply and diminishing returns.
Gateway markets are also home to the kind of stability many institutional investors like pension funds crave when building out a portfolio.
A portfolio will be built around an initial investment in real estate in major metropolitan areas, and then smaller markets will see capital when those investors seek higher returns.
Sovereign wealth funds, insurance companies and pension funds accounted for 30% of inbound investment to the primary U.S. markets of Manhattan, Los Angeles, Seattle, Chicago and Boston during the first half of 2019, compared to only 3% in secondary markets, according to CBRE.
“Institutional capital likes to be safe, and there’s safety in following,” Reiter said. “That’s not a criticism. It’s just an observation. If you’re sitting at one of these big firms, the last thing you want to do is make a mistake.”
Risk-averse firms avoid buying into a secondary market where they may not be able to cash out at a price — or timeline — acceptable to investors. Secondary markets may have greater upside, but they also have more volatile economies in comparison to gateway markets.
On a seven-year investment fund, investors must take into account the likely liquidity in the market when then try to sell on that timeline, Sussman said. There might be a great property with the potential for a significant return in a secondary or tertiary market, but there is less certainty on who the buyer will be on the other side.
“That’s never a concern in a primary market because there are plenty of buyers,” Sussman said. “If you have a $300M deal in Cincinnati or Columbus, what is the depth of buyers who can take you out at that point? That’s a concern investors have.”
While companies like JPMorgan may seek lower-cost markets to house employees, there are plenty of others, especially in the technology and life sciences sector, who double down on pricier coastal cities.
“It’s why you see companies saying ‘fix your infrastructure’ to cities instead of just moving out,” CoStar Portfolio Strategy Consultant Joseph Biasi said.
In Greater Boston, three dozen companies in Kendall Square, the country’s tightest and most-expensive life sciences submarket, joined in a letter to Massachusetts officials to fix the region’s transit network, which is prone to breakdowns. Across the country in the Bay Area, Facebook and Google have pledged $1B each to generate affordable housing in the country’s costliest housing market.
Even though Amazon chose Nashville for a 5,000-job consolation prize in its search for a second headquarters, the fact that it initially chose to put 25,000 employees in each of Washington and New York for HQ2 signaled the company is limited in cities where it can actually scale up its workforce. While analysts still expect secondary markets in the Sun Belt to perform well, they don’t expect CRE’s strong preference for top-tier cities to go away.
“The demographics in secondary markets might be getting better,” CoStar Portfolio Strategy Senior Consultant Juan Arias said. “But the CRE fundamentals still aren’t there.”