a tale of
two cities
Investing in U.S. Commercial Real Estate
©2016 First American Financial Corporation and/or its affiliates. All rights reserved. NYSE: FAF
Linda J. Isaacson
SVP, Director of Business Intelligence
First American Title Insurance Company
National Commercial Services
Unless otherwise indicated, statistics are for properties and portfolios valued at $2.5 million and greater. They are based on Real
Capital Analytics, Inc. data and data generated and evaluated by First American Title Insurance Company analysts. Data Source:
© Real Capital Analytics, Inc. 2016. Data is believed to be accurate; however, its accuracy is not guaranteed.
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A Note From The Writer
I
ncreased demand for U.S. commercial real estate assets and a maturity in the property cycle driven by economic
growth have been major contributors to the volume of commercial real estate in the United States. But game
changers, including technology, an undeniable urbanization shift, the impact of collaborative communities,
employment instability, changing demographics, transit connectivity and other infrastructure issues add a dimension
and complexity to the variables affecting CRE. These factors may continue to shape the real estate landscape of
certain cities as they generate economic growth, while others remain unaffected. A bifurcation of metros into urban
and non-urban markets is developing into a “tale of two cities.” I’m excited to share new insights about the major
metro gateway cities and secondary markets, and why they’re the most likely destinations for investment in 2016.
This white paper is the result of collaboration with my First American Title Insurance Company colleagues. In
particular, credit goes to Pranay Bolneni and Emilee Noll on the Business Intelligence team. In addition, it is always
thought-provoking to learn from First American’s Chief Economist Mark Fleming, who probes and tests the theories
in so many insightful ways.
New York City, Central Park
Gateway vs. Non-Gateway, Urban vs. Non-Urban,
Thriving vs. Distressed
F
or a multitude of reasons, there is a significant amount of liquidity and transactional volume in the U.S. commercial
real estate market. Increased aggregate demand for U.S. commercial real estate assets, and a maturity in the
property cycle driven by economic growth, have certainly been major contributors. At the same time, the global
economy only grew by roughly 3 percent in 2015. Not only is this rate below the average per annum growth rate of
3.5 percent that has prevailed over the past 35 years, but it also marks the slowest rate for global GDP growth since
New York City
the global economic downturn in 2009.1 Investors, especially those from outside the United States, have shown distinct
geographical preferences for their acquisitions, leading to a wide disparity between transaction volumes and pricing
in gateway and non-gateway markets. There is also a great gap in terms of the degree of investment in thriving versus
distressed cities and urban versus non-urban markets. These factors and a number of trends such as “innovation hubs”2,
may continue to shape the real estate landscape of certain cities as they generate economic growth, while others do
not. A bifurcation of metros into urban and non-urban markets is developing into a “tale of two cities”, with a distinct
and major dichotomy in U.S. commercial real estate investment.
Propelling Investment
C
ities that are “innovation hubs” which thrive and generate wealth, will propel even greater investment, and the
tale may become more pronounced. “More than traditional industries, the knowledge economy has an inherent
tendency toward geographical agglomeration [clusters].”3 Increasing demand for digital technology and society’s
changing lifestyles are forcing owners to adapt their properties as former uses become obsolete. Yet, the bifurcation
also exists in large part because of the appeal of U.S. properties to both international and domestic investors in a period
of economic and geopolitical turmoil. Investors ranging from Canadian pension funds to high-net-worth individuals
from China are looking to U.S. commercial real estate as a safe haven.4 As U.S. stock markets have become more
volatile, capital investment has shifted in response.
The 2016 Pension Real Estate Association Investment Intentions Survey5 notes that, on average, institutional investor,
fund manager and fund-of-fund manager investment capital, is under-allocated in real estate by at least 1 percent, with
investors from the Asia-Pacific region planning to increase their international diversification and reduce investment
in their home markets. Investors responding to the survey expect to place $57.9 billion in real estate in 2016, with
approximately two-fifths of that coming from each of Europe and North America, and one-fifth from Asia-Pacific.6
Wells Fargo Securities, Economics Group, Global Chartbook: March, 2016.
The New Geography of Jobs, Enrico Moretti, First Mariner Books, 2013.
Id.
4
Total Global CRE Volume in 2015 $1.2 trillion, - 2% Year-Over-Year. Total U.S. CRE Volume in 2015 $533 billion, + 22% Year-Over-Year. Total Foreign Investment Volume to U.S. $91 billion, +125% Year-Over-Year
5
Pension Real Estate Association, (PREA) Investment Intentions Survey 2016. The survey conducted from October through November 2015, evaluated responses from 130 Institutional Investors, 200 Fund
Managers and 15 Fund-of-Fund Managers. Collectively they had $2.4 trillion in assets under management. www.prea.org.
6
Id.
1
2
3
1 | Page
Of this amount, 35 percent is expected to be
invested in the United States.7 CBRE notes
that investors from China placed more than $8
billion in U.S. commercial real estate in 2015,
excluding investment in real estate development
deals.8 China investor deals include the
transformative pending acquisition by Anbang
Asset Management Co., Ltd.9 of Blackstone
Group’s Strategic Hotels & Resorts for $6.5
billion. In fact, one of the primary drivers of
U.S. commercial real estate originated from
the net acquisitions of international investors,
as compared to the net dispositions by nearly
every other investment group in 2015.
Chicago
The first bifurcation in commercial real estate
funding in the United States is seen in the
differing investment strategies employed by
these foreign and domestic investors. The
gateway cities, as defined further in this paper,
likely will remain the most popular destinations
for investment in 2016, as investors from outside
the United States pursue trophy properties
in major gateway cities such as New York,
Chicago and Los Angeles. Such investment is
driving prices up to significant levels and cap
rates down to where these investments are
purely for yield, much like a blue-chip stock in
previous decades.
Foreign investment may be impacted further
by changes to The Foreign Investment in
Real Property Tax Act of 1980 (FIRPTA)10 that
address the tax treatment of foreign investors’
direct and indirect holdings of U.S. real estate.
Those changes were made primarily to reflect
(i) The tax on qualified foreign pension funds
shareholders, (ii) Expanded domestically
controlled REIT provisions, (iii) Restriction
of public REIT shareholders to ten percent
ownership interests, and (iv) The addition of
a new 15 percent FIRPTA withholding rate.11
While institutional overseas investors continue
to target primarily major markets, United States
domestic investors remain focused on a larger,
more diverse geographic region. Investors in
the United States tend to spread the wealth,
investing in both primary and secondary cities.
Id.
http://www.cnbc.com/2016/01/08/china-stock-swoon-could-boost-us-real-estate.html.
9
Anbang Asset Management Co., Ltd. is the investment arm of Anbang Property & Casualty Insurance Co. Ltd.
10
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), enacted as Subtitle C of Title XI (the “Revenue Adjustments Act of 1980”) of the Omnibus Reconciliation Act of 1980, Pub. L. No. 96-499, 94
Stat. 2599, 2682 (December 5, 1980), amended by The Protecting Americans from Tax Hikes Act of 2015 (PATH Act), which were signed into legislation on December 18, 2015.
11
Robert LeDuc, “The Path Act: Impact on Foreign Investment in U.S. Real Estate,” Pension Real Estate Association (PREA) Spring Conference, March 8, 2016.
7
8
2 | Page
Even so, certain market qualities affect pricing, cap rates and volume in all markets: for example, the walkability of a
city’s central business district (CBD) and the quality of its public transportation system. While there are many cities in
the United States which may be defined as gateway, including but not limited to Atlanta, Boston, Dallas, Miami, San
Francisco, Seattle and Washington, D.C, this paper examines three major metro gateway cities — New York, Chicago
and Los Angeles — and three secondary markets — Austin, Denver and San Jose — and discusses how the desire for
an urban lifestyle is leading to very different investment strategies and outcomes. But one thing these cities all have
in common is a great deal of innovation and college-educated inhabitants. Several are billed as “The Most Innovative
Cities in America’, with New York the most innovative, and Chicago the 4th most innovative city in the U.S.12 New
York, a world-class innovation city, as well as others mentioned in this paper, may be getting even stronger over time.
Los Angeles
G ateway Cities vs. Secondary Markets (Pricing, Cap Rates & Volume) 13
I
f one accepts the standard definition that a gateway city is an “entry point to or from a country; a primary arrival and
departure point, typically an airport or seaport,”14 New York, Chicago and Los Angeles clearly fit the definition. All
three cities have seen property prices rise in the post-recession era as compared to secondary cities, according to the
Moody’s/Real Capital Analytics Commercial Property Pricing Indices (Moody’s/RCA CPPI™). The inverse relationship
between pricing and cap rates, particularly between gateway and secondary cities, presents an interesting dilemma for
investors, as location, sector and demand drivers remain important considerations when determining their strategies.
No U.S. city more clearly typifies bifurcation than New York City, specifically Manhattan, where the commercial property
price index (CPPI) nearly tripled from 174.0 in 2009 (the recessionary nadir) to 513.2 in 2015 (based on a benchmark
of 100 in 2000). In fact, likely the New York metro area will remain more popular with non-U.S. stakeholders than
domestic investors, with more than 50 percent of foreign entities indicating intentions to acquire properties there,
http://chicagoinno.streetwise.co/2014/10/08/cnn-ranks-chicago-the-4th-most-innovative-city-in-america.
Unless otherwise indicated all pricing data contained in this section is from Moody’s/RCA CPPI™, Moody’s/RCA Commercial Property Price Indices, published by Real Capital Analytics (RCA) and Moody’s
Investors Service, 2016 and all volume data is from Real Capital Analytics, Inc. 2016 © Real Capital Analytics, Inc. 2016. The Moody’s/RCA CPPI™ uses advanced Repeat-Sale Regression (RSR) methodology of
qualified repeat sale observations to measure price change in commercial real estate. Base Date 2000 = 100.
14
BusinessDictionary.com.
12
13
3 | Page
Austin
topping all cities in the 2016 Pension Real Estate Association Investment Intentions Survey.15 New York is followed by
Boston, San Francisco, Chicago and Los Angeles.16 Los Angeles, digital entertainment capital of the world, too, has seen
real property pricing rise, from 163.0 in 2009 to 275.2 in 2015, a 69 percent increase. In contrast, the index for the
United States as a whole rose 45 percent, from 144.3 in 2008 to 209.0 in 2015. As of year-end 2009, due to a precipitous
drop in pricing, all asset classes collectively realized a net gain of 96 percent in the pricing index through 2015. For
the prior five-year period, Chicago remained a favored destination of institutional investors, much like New York, Los
Angeles and Boston during the same period.
The secondary cities, too, have seen noteworthy gains. For example, Austin is a city undergoing intensive urban
regeneration. The city’s index rose 127 percent, from 84.9 in 2009 to 192.3 in 2015. Denver’s pricing doubled during
the same period, increasing from 85.9 to 188.3. San Jose, which bills itself as the largest city in the Bay Area, has seen a
twofold rise from 109.7 to 228.9, while nearby San Francisco’s index tripled from 106.2 in 2009 to 320.0 in 2015. With
a high concentration of engineering, microprocessor and high-tech companies, San Jose, the county seat of Santa Clara
County is considered to be the capital of Silicon Valley.17 It has a growing population of young professionals and expert
technologists, and is attracting a globally diverse workforce and investors to follow.
At the same time, cap rates have compressed more significantly in the gateway cities, where intense competition
continues to reduce investment yields for core real estate. Manhattan real estate now commands a cap rate of 4.07
percent through the end of 2015, down from 6.02 percent in 2009. Los Angeles also saw a decline, from 6.41 percent
in 2009 to 5.21 in 2015. Likewise, rates have dropped in smaller markets, from 8.01 percent in 2009 to 6.56 percent in
Austin, from 7.77 percent in 2009 to 6.59 percent in Denver, and from 6.88 percent in 2009 to 5.44 percent today in
San Jose.
Pension Real Estate Association, (PREA) Investment Intentions Survey 2016. www.prea.org.
Id.
17
http://www.forbes.com/places/ca/san-jose.
15
16
4 | Page
Transaction volume indisputably is a key factor, with many roads continuing to lead to New York. Manhattan real
estate transactions totaled $62.1 billion in 2015, a 36.3 percent increase over the previous year.18 International
investments represented a disproportionate 38 percent of this volume. Los Angeles’s 2015 transaction volume of
$28.3 billion was a 3.2 percent increase over the previous year19, but certain market anomalies, discussed later in
this paper, make L.A. unique.20 Private domestic investment drove more than 50 percent of all investment activity in
the Los Angeles market. Although secondary cities are not attracting as much investment as gateway cities, they are
seeing meaningful gains on a much smaller scale. In 2015, Austin saw a 17.2 percent rise year-over-year in volume to
$7.8 billion.21 Denver posted a 21.4 percent increase to $10.9 billion.22 Bolstered by its world-renowned reputation
as a premier destination for millennials (and for a few blockbuster acquisitions), San Jose saw a 49.2 percent increase
in transaction volume to $13.4 billion.23 Once again, private investors represent the primary group participating in
these markets, as reflected in Austin (48 percent), Denver (56 percent) and San Jose (32 percent).24
Freedom tower and OCULUS, The World Trade Center Transportation Hub
Clearly, investors are continuing to flock to the “haves” among U.S. cities. The question is why? Why, despite soaring
prices and collapsing cap rates, do gateway cities, especially New York, continue to attract investment? The theory
comes down to even greater divergence in the infrastructure of the cities themselves, and the need to appease a
new generation of well-educated, millennial, tech talent and knowledge workers, as well as a population seeking to
“age in place”. Thus, cities are expanding to accommodate urbanization, a notable example being the Hudson Yards
redevelopment project in New York.
Data Source: © Real Capital Analytics, Inc. 2016.
Id.
20
See Page 7.
21
Id.
22
Id.
23
Id.
24
Id.
18
19
5 | Page
Walkable vs. Non-Walkable Central Business Districts (CBDs) 25
O
ne of the greatest ongoing demographic changes in the United States has been the shift away from auto dependence,
particularly among young and older adults. Increasingly, Americans want to live, work and play in the same area,
saving commuting time, cutting costs and even making an environmental impact. According to a University of Michigan
study, 76.7 percent of those between the ages of 20 and 24 had a driver’s license in 2014, down from 82.0 percent
in 2008.26 The percentage of license holders also declined among those between the ages of 60 and 64, from 95.9
percent in 2008 to 92.1 percent in 2014.27 To accommodate this new auto-less workforce, leading corporations have
relocated their headquarters or major office locations from suburban campuses to gateway cities and smaller urban
areas: General Electric Co. from Fairfield, Conn. to Boston; Kraft Heinz from Northfield, Ill. and Motorola Solutions,
Inc. from Schaumburg, Ill. to Chicago; Expedia, Inc. from Bellevue, Washington to Seattle, and PepsiCo from Somers,
N.Y. to White Plains. Despite appreciable higher rents than in the suburbs, downtown CBDs are now more appealing
to investors and to businesses competing globally, and fighting the war for talent.
In fact, there is a direct correlation between the walkability of a city’s CBD and the prices of commercial real estate.
Prices in cities designated as “Very Walkable” by Walk Score, such as New York, San Francisco, Boston, Philadelphia,
and Miami, have risen 125 percent over the last decade, while suburban prices only rose 43 percent. At the same time,
cap rates have declined for the “Highly Walkable” “Six Major Metros” (New York, Los Angeles, San Francisco, Chicago,
Washington, D.C. and Boston), which had 4.87 percent cap rates last year. “Highly Walkable” U.S. cities had an overall
5.43 percent cap rate. Both rates are still lower than the U.S. cap rate of 6.49 percent, which includes all asset types.
In general, the Six Major Metros, with a “Highly Walkable” CBD according to Moody’s/RCA Commercial Property Price
Indices, had a 23.07 percent year-over-year price index gain in 2015 to 390.6, nearly triple the 2009 index of 137.5.29 According
to Walk Score, New York, the most walkable city in the United States in 2015, also tops property pricing and transaction
volume. Chicago, ranked eighth by Walk Score, also saw significant investment. Meanwhile, “Car-Dependent” Austin (74th),
“Somewhat Walkable” Denver (29th) and “Car-Dependent” San Jose (35th) lag in terms of volume.30 It is evident that there
is a direct relationship between pricing, volume and walkability, and an indirect relationship with Cap rates. These factors
further illustrate the divide between gateway and non-gateway and walkable and non-walkable metro areas.
LA Live
Unless otherwise noted, all of the walk score metrics contained in this section came from Walk Score® www.walkscore.com.
University of Michigan Transportation Research Institute, “More American’s of all ages spurning driver’s licenses,” January 20, 2016.
27
Id.
28
Moody’s/RCA Commercial Property Price Indices, published by Real Capital Analytics (RCA) and Moody’s Investors Service, 2016. Moody’s/RCA CPPI™.
29
Id.
30
Data Source: © Real Capital Analytics, Inc. 2016.
25
26
6 | Page
Even the one city that could be considered an anomaly among gateways, Los Angeles (once jokingly called “Six Suburbs
in Search of a City”),31 came in 18th on the Walkability Index, with a downtown that is now considered “ripe for
innovation and contemporary mixed-use development.” 32 It is telling that major foreign investment and development
in downtown L.A. are transforming the city, making the downtown CBD far more urban, walkable and desirable.
A 1999 ordinance that allowed adaptive reuse of historical buildings has created a SoHo-like explosion of loft and other
multifamily residences (more than 10,000 are under construction, according to Downtown LA33), with restaurants and
retail following in the wake of LA Live, the entertainment complex in the South Park District of downtown Los Angeles.
This has now drawn other investment, particularly from Asia, including:
n Greenland USA, a subsidiary of Greenland Group, that is building the $1 billion Metropolis in South Park, a
mixed-use project on 6.3 acres north of LA Live, which includes Hotel Indigo, residential condominium towers,
and both retail and commercial space
n The proposed Oceanwide Plaza, on 4.6 acres across from Staples Center, proposed by Beijing-based
Oceanwide Holdings Co., Ltd., which includes retail, commercial and entertainment space
n Shenzhen Hazens Real Estate Group’s redevelopment of the Luxe City Center Hotel, a mixed-use project with
a W Hotel, condominium units and 80,000 square feet of retail space
The L.A. Metro, the Los Angeles metro rail system, stops in the region, DASH34 buses connect to citywide lines, and
there are plans to add a streetcar system to connect the Civic Center and Bunker Hill to South Park and LA Live, which
will create an interconnected submarket more akin to those in New York and Chicago than those in the western city
section of Los Angeles metro. Los Angeles Transit Score ranked the city of Los Angeles 17th in the country, at 51.3,
which indicates solid transportation options with a “Good Transit” rating. “Investors and developers from New York
to Asia are seeing [the] potential [of Los Angeles metro], as they are investing in the downtown office market, with
an emphasis on ‘office of the future’ workspaces, especially in South Park, City West and the Financial District.”35
Comparatively, New York’s transit system is ranked first at 84.1, and is included in the “Excellent Transit” category.
Although no U.S. city has yet achieved “Rider’s Paradise” status, a rating of 90 or above, clearly, road, rail and public
transportation are proving vital for urban success.
Walk Score Legend
Walk Score
Definition
Description
90 - 100
70 - 89
50 - 69
25 - 49
0 - 24
Walker’s Paradise
Very Walkable
Somewhat Walkable
Car-Dependent
Car-Dependent
Daily errands do not require a car
Most errands can be accomplished on foot
Some errands can be accomplished on foot
Most errands require a car
Almost all errands require a car
Transit Score Legend
Transit Score
Definition
Description
90 - 100
70 - 89
50 - 69
25 - 49
Rider’s Paradise
Excellent Transit
Good Transit
Some Transit
Minimal Transit
Provides world-class public transportation
Transit is convenient for most trips
Many nearby public transportation options exist
A few nearby public transportation options exist
It is possible to get on a bus
0 - 24
David James, The Most Typical Avant-Garde: History and Geography of Minor Cinemas in Los Angeles (University of California Press 2005).
Outlook on Downtown Los Angeles Real Estate 2016 © 2016 Ernst & Young LLP. 33 PwC Real Estate 2020: Building The Future, 2016.
DASH is the bus service in downtown Los Angeles and in 27 neighborhoods across the City of Los Angeles.
35
PwC Real Estate 2020: Building The Future, 2016.
31
32
34
7 | Page
San Jose
U rban vs. Suburban
W
hile New York and Los Angeles dominate even the healthiest of secondary cities in terms of dollar investment
in commercial real estate, investors clearly prefer urban markets to suburban markets today. An analysis of the
data shows that transaction volume in the Six Major Metros has increased nearly tenfold since the market hit bottom
in 2009, going from $29.5 billion in that year to $246.4 billion in 2015. In comparison, the overall 2015 U.S. volume of
$539.9 billion shows less than an eightfold increase for the same period. The decline in cap rates in the United States,
from 7.41 percent in 2009 to 6.49 in 2015, roughly parallels the drop in “Somewhat Walkable” non-major metro areas,
from 7.89 percent in 2009 to 6.82 percent in 2015.36 Perhaps even more telling is the post-recession difference among
rising pricing indices of the Six Major Metro areas’ “Highly Walkable Central Business Districts” (from 137.5 to 390.6),
the same areas’ “Highly Walkable Suburbs” (147.4 to 261.4) and non-major metros’ “Somewhat Walkable Suburbs” (97.7
to 173.7).37 Clearly, investors prefer sidewalks in central business districts.
Chicago
36
37
Moody’s/RCA Commercial Property Price Indices, published by Real Capital Analytics (RCA) and Moody’s Investors Service, 2016. Moody’s/RCA CPPI™.
Id.
8 | Page
E stablished vs. Distressed Cities
S
idewalks are not the only consideration, nor are they necessarily the most important factor. An established urban
market such as Detroit, known as the “Motor City,” could be an affordable investment alternative as the home of a
rebounding auto industry. Despite the fact that Detroit is the fourth largest city in the Midwest, it is not a gateway city. It
lacks a major seaport, and it has remaining degrees of distress in its central business district. Of the ten most distressed
large cities in the U.S., Detroit ranks number one based on educational attainment, housing vacancy rates, employment
levels, income levels, and percent change in the number of establishments.38
Yet another influence is the “cool factor,” which is attracting a whole new class of investors — ones willing to invest
hard cash in marginal markets. Thus, those seeking true value-added investments and willing to take on risk are
targeting distressed markets such as Detroit or Baltimore. Detroit’s pricing index rose from 86.5 in 2009 to 133.9 in
2015, with last year’s transaction volume at just $3.2 billion (albeit a huge increase over 2009’s investment volume of
$457.5 million).39 At least at this point, investors prefer a more certain return in the Big Apple over the possibilities
of big gains in Motown. Boston, a mecca for higher education, presents an alternative as a more “mature” market for
significant investment. Boston’s pricing index rose 93 percent from 2009 through 2015.40 The city’s volume growth
mirrored that of the United States.
Business Insider, The Economic Innovation Group, July 2015. 39 Moody’s/RCA Commercial Property Price Indices, published by Real Capital Analytics (RCA) and Moody’s Investors Service, 2016. Moody’s/
RCA CPPI™.
40
Id.
38
9 | Page
L ooking Ahead
H
ow will investors balance risk when determining their investment strategies? One thing is certain, they will need
to analyze not just gateway vs. secondary markets, but core vs. noncore and opportunity vs. value-add as well.
The high prices and low cap rates in New York prove the value of the ultimate gateway city’s offerings — a seaport,
home to multiple international airports and eminently walkable. The rising prices there, and in other gateway cities,
may make investments in trophy properties in these markets possible for only the wealthiest individuals, sovereign
wealth funds and pension funds, each of which will likely buy and hold properties as reselling at any significant gain
is unlikely at or in the near future. These investments are long-term, safe harbors, despite the fact that prices will
remain highly competitive. “New wealth from the emerging economies will intensify competition for prime assets; the
investment community will need to think laterally to earn attractive returns.”41 Those investors seeking growth may turn
to secondary cities as they search for affordability, diversification and innovation. According to the 2016 Pension Real
Estate Association Investment Intentions Survey, “While non-U.S. capital is definitely more concentrated [in] the major
markets, there is still a significant minority of investors from Asia-Pacific and Europe that intend to invest outside the
gateway cities.”42
However, it is clear that, at least for 2016, U.S. commercial real estate remains a case of the cities that seem to have it all
(New York, Los Angeles and Chicago) drawing the bulk of the attention — and the monies — from the less walkable
secondary cities, those that lack. But, the most innovative secondary cities, will also provide investment opportunities
and capital appreciation.
Denver
Conclusion
I
n the eighth year of the economic recovery, some shifts are to be expected. In January 2016, we witnessed a 0.3%
decline in the Moody’s/RCA CPPI™ index, the first monthly decline in six years.43 We are already seeing the impact
of a worsening debt outlook for the U.S. economy. Further, the federal deficit is expected to rise over the next ten
years, from 2.9 percent of GDP in fiscal year 2016 to 4.9 percent in 2026.44 Expansion in the global economy likely
will stay slow. Moreover, the global economy will remain vulnerable to negative shocks. The confluence of events
and trends such as urbanization, wealth-generation, tech-innovation, mobility of human capital and sustainability will
be key drivers as competition between cities intensifies. This means that the commercial real estate environment will
be particularly interesting, and perhaps more volatile. U.S. commercial real estate investment may increase as global
political and economic jitters send both domestic and foreign investment to the U.S. for safety and transparency. The
“tale of two cities,” and the future of ambitious, innovative and growth-oriented markets and investors may become
even more divergent, accelerated and evident over time.
PwC Real Estate 2020: Building The Future, 2016.
PREA Investment Intentions Survey 2016.
43
Moody’s/RCA Commercial Property Price Indices, published by Real Capital Analytics (RCA) and Moody’s Investors Service, 2016. Moody’s/RCA CPPI™.
44
Wells Fargo Securities Economics Group, “2016 Federal Fiscal Policy Outlook Part 3: The Land of the Rising Deficits,” March 15, 2016.
41
42
10 | Page
a tale of two economies
Mark H. Fleming, SVP
First American Financial Chief Economist
T
he well-documented demand for commercial real estate in gateway versus non-gateway cities is driven by very
different forces. In particular, there are two demand sources that are playing predominantly influential roles in
these commercial real estate markets today — foreign investors and millennials, yet each for different underlying
economic reasons.
Foreign investors, as has been shown, have particular interest in commercial real estate assets in gateway cities such
as New York, San Francisco, and Chicago. Why is real estate so attractive to foreign investors in these markets and
why have they effectively bid prices ever higher and driven yields even lower? First, U.S. commercial real estate is
viewed, among all global investment opportunities, to be a relatively safe asset class. Late last year, the IMF published
its’ world economic outlook in which it outlined the state of economic affairs across the globe. Slowing growth,
falling oil and commodity prices, a faster slowdown in China’s growth rate and increased geopolitical tension are
all contributing to the increased attractiveness of U.S. commercial real estate assets. Furthermore, while the dollar
has strengthened recently relative to other countries, over the last few years it has been weak. This directly and
beneficially influences, the affordability of U.S. commercial real estate assets for foreign buyers.
Domestic millennial first-time buyers are driving commercial real estate demand in many secondary markets like Austin,
Denver and San Jose as they seek attractive job opportunities found in those locations. Strong and growing labor
markets drawing well-educated and highly paid talent to these markets is causing economic expansion. While the direct
demand for amenity-rich multifamily housing is driving up prices, other commercial real estate asset classes are also
benefiting from the broad economic impact that in-migration causes in a local economy. The renter millennial needs to
shop, eat, and play somewhere, which helps to increase demand across commercial and real estate sectors.
Whether a gateway city or secondary market, healthy economies and strong real estate demand are fundamentally
driven by the underlying labor market. In particular, real estate demand benefits from labor markets that provide
high paying jobs, which usually require more education. New York and San Jose are no exception. In fact, the share
of households in New York where the head-of-household has a bachelor’s degree or higher has increased from 34
percent in 2001 to 43 percent in 2015, and as a result median household income has increased 36 percent. In the
secondary market of San Jose the share of households with a bachelor’s degree or higher has increased from 49
percent in 2001 to 54 percent in 2015, and as a result median household income has increased 32 percent.45
Cities are attractive if they offer good job opportunities, strong transportation infrastructure and walkable lifestyles.
While these attractive markets might appeal to a diverse set of buyers, foreign investors in gateway cities or young
millennials in secondary cities, the tale of economic outcomes are quite similar. High demand for commercial real
estate driving up prices and reducing cap rates. Foreign investors may lessen their demand as the dollar strengthens,
but the influence of millennials and their migration to “innovation hubs”, will only grow stronger in the coming years.
45
IPUMS-CPS, University of Minnesota, www.ipums.org.
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