Urbanization and Related Investment Analysis

Broad demographic trends point to continued urbanization in the United States. How does this trend inform real estate investment risk analysis?

Home Buyers Want Cities – or Nearby Suburbs

Several observers — including Robert Shiller, a 2013 Nobel laureate in economics, professor of economics at Yale University and the co-creator of the S&P CoreLogic Case-Shiller Index for housing — have long pointed to how demand has recently skewed toward homes in central cities, sometimes even at the expense of more spacious distant suburbs.

Suburbs of major metropolitan areas, though, aren’t likely to wither away and die anytime soon.  Suburbs still account for 79 percent of the population, 78 percent of households, 32 percent of land area, and—despite popular and media perception—75 percent of 25- to 35-year-olds.

For smaller towns and cities, though, the economic environment is increasingly risky.  Economic “geography” matters when evaluating a real estate investment opportunity, and despite the political calls to help people in such quasi-rural areas, the current evidence discussed below continues to indicate that investing in smaller towns and cities is increasingly risky.

Towns and Smaller Cities Face Increased Relevancy Risks

Until recently, towns and small cities served as providers of services to a larger rural population engaged in agriculture and other natural resource-based activities. The rural population was dispersed because arable land and other resources were dispersed—and so there were many small cities dotting the landscape. Observing this effect, academics have developed a “central place theory” to try to explain the number, size and location of human settlements in a residential system.

As agriculture has become less important as a share of the economy, however, rural populations matter less in determining urban locations. Nevertheless, many small cities have survived and grown by becoming small industrial centers. A recent New York Times article provides the example of Rochester, New York; originally a flour milling center, a German immigrant later started a company making monocles, which itself later became a major producer of glasses, microscopes, and all things lens related. Rochester thus became a place where people knew about optics—which likely led to the rise of Eastman Kodak and, later, Xerox.  Yet even now, those industries are failing, and Rochester is having difficulties.

Not all small cities are even that lucky.  While some localized industries create fertile ground for new industries to replace them, others can become became dead ends. A big, diversified city can afford a lot of dead ends; a smaller city can’t. In the modern economy — which has cut loose from the land — a small city often exists only because of historical contingencies that, sooner or later, lose their relevance.

The companies that now drive the wealth of major metropolitan areas—and that represent the part of the American economy that’s booming—don’t always need the help of towns in other parts of the country in the same way as in days past where these smaller cities would provide basic parts or natural resource components needed for a finished manufactured product. Now, larger cities are less dependent on regional or other local links.

“These types of urban economies need other major urban economies more than they need the standardized production economies of other cities in their country,” said Saskia Sassen, a sociologist at Columbia University who has long studied the global cities that occupy interdependent nodes in the world economy. In other words, New York needs London—but who now needs Rochester?

“These [regional] links have been broken,” said Richard Longworth, a distinguished fellow with the Chicago Council on Global Affairs. Of course, antipathy toward prosperous big cities is not a new theme in history. “But this is different: This is deeper,” said Mr. Longworth.  “It is also, as far as we can see, permanent, simply because the economy that supported the earlier relationships has gone away and shows no sign of coming back.”

Such a picture, Ms. Sassen said, “breaks a past pattern where a range of smaller, more provincial cities actually fed the rise of the major cities.” Now major cities are feeding one another, and they’re apparently no longer tied to local businesses in the “hinterland” communities; those smaller towns and cities have either lost their role in the modern economy or have failed to adapt to international competition.

Investors Might Pay Attention to Metropolitan Statistical Areas

In the website portion of its offering materials, RealtyShares often notes the “metropolitan statistical area” (MSA) in which a property is located.  MSAs are defined by the federal Office of Management and Budget (OMB) and used by the Census Bureau and other federal government agencies for statistical purposes.

In general, although RealtyShares often targets investment opportunities in secondary or tertiary markets, RealtyShares still focuses on investment opportunities in MSAs with a population of 100,000 or more.  This underwriting focus is precisely because of the risks faced by property in smaller places—the urbanization trend does not favor areas that have not acquired some sort of critical mass.

As the U.S. economy trends away from manufacturing and more toward a knowledge and service economy, that newer economy favors the exchange of ideas and “agglomeration” economies that result when firms and people locate near one another—developments that favor cities generally and larger cities in particular.

Even Suburban Office Complexes Are Increasingly Community-Focused

The same agglomeration trends involving the clustering of economic activity is playing out even in localized facilities such as suburban office facilities.  Property owners in some suburbs are remaking corporate campuses to include features such as modern fitness centers, bike-share programs, walking trails and spacious lobbies as spaces to socialize. “It’s all about landlords trying to attract tenants, and tenants trying to attract millennial recruitment,” said Daniel Loughlin, broker lead of real-estate services firm JLL’s New Jersey office.

Onyx Equities, for example, is doing a makeover at a building in Morristown, N.J. Onyx is putting in a glass facade, new mechanical systems and a new lobby, as well as amenities such as a cafeteria and conference areas. “The only buildings that are leasing are buildings that landlords are investing in,” said Tim Greiner, executive managing director at Newmark Grubb Knight Frank, which is leasing the building for Onyx.

J.C. Penney Co. — not always known for innovation in retailing — has nonetheless recently been a trailblazer when it comes to real estate. It is redeveloping its suburban campuses in Plano, Texas to denser, more urban settings, where businesses can give employees the option of living, working and playing with minimum time spent in automobiles. And an older campus that it sold a few years ago has already lured Toyota Motor Corp.’s North American headquarters from California as well as major operations of J.P. Morgan Chase & Co., FedEx Corp. and Liberty Mutual Insurance Co. That section will have a mix of apartments, stores and restaurants called Legacy West. “Legacy West is urbanizing the suburbs,” said Karen Whiteknact, a senior vice president with Boston-based Liberty Mutual.

As a younger workforce gravitates to more downtown settings, companies are feeling isolated in glass and steel headquarters tucked into acres of parkland and forests. “The smart money is buying these campuses cheap, opening them up and tying them into communities,” said Joseph Brancato, a principal of Gensler, an architecture firm working on transforming four different corporate campuses.

 

 

Lawrence Fassler
Corporate Counsel

Lawrence has over 15 years’ experience as a corporate attorney and has also run a real estate construction business. He previously worked with Realty Mogul, AVE (acquired for over $4 billion), Shearman & Sterling in NYC, and Cooley in their Sand Hill Road office.


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