November 2017 – BY LORETTA CLODFELTER
Twenty-five years ago, the central business district was dead, felled by a long-term trend of corporations moving offices to suburban campuses as they followed employees, who were moving out of cities. In the past decade, however, the pendulum swung in the opposite direction. CBD office and apartments came back into favor. City centers were fun, walkable, dense and safer than before. People, especially millennials, wanted to live and work in downtowns, and the real estate industry responded.
But could that pendulum be preparing to swing in the other direction? Or are downtown and suburban real estate entering equilibrium?
Little boxes
The seeds of suburbia’s downfall (and, perhaps, its rebirth) were planted decades ago. The suburbs, embraced by baby boomers as a safe haven to raise families away from the noise and crime of the big city, were viewed by their children as stifling and conformist — ticky-tacky little boxes that all looked the same.
The commercial real estate of the suburbs was similarly generic — an office park on the outskirts of Cleveland looked like an office park on the outskirts of Dallas looked like an office park on the outskirts of Philadelphia. A regional mall in California had the same department stores and chain restaurants as a regional mall in New Jersey. By the early 2000s, development had moved outward from city centers to suburbs and even exurbs.
“Prior to the global financial crisis, in the early to mid-2000s, we witnessed the decentralization of employment from CBDs to suburban locations,” says Abby Corbett, director of research at Ascentris. Between 2000 and 2007, employment closest to CBDs declined by 4.2 percent, while employment within three to 10 miles of CBDs increased by 2.3 percent, and employment outside of 10 miles from the CBD increased by 9.6 percent. “This sparked a substantial suburban office development cycle, but the timing was inopportune because it occurred during the two to three years prior to the global financial crisis,” notes Corbett.
“Once the recession hit, we witnessed a flight-to-quality trend among tenants, whereby ‘higher-quality’ assets, oftentimes in the CBDs, were able to offer highly attractive rents when compared to their suburban counterparts,” adds Corbett.
What the suburbs of the past lacked — and what downtowns had in abundance — was cool. Now, cities offer hip restaurants and cool boutiques, exciting nightlife and clusters of young people, creative office space and loft apartments. In the wake of the global financial crisis, downtown office and apartment properties were in high demand from buyers and tenants. A surge into downtowns came out of the recession, a wave of absorption into urban cores paired with the belief suburban office was dead. And developers took notice.
“High-barrier-to-entry markets have seen the vast majority of the supply this cycle, and it’s largely a function of developers believing replacement-cost rents now justify building,” says Chad Burkhardt, senior vice president with CenterSquare Investment Management. Suburban office properties, for example, are trading below replacement cost. Developers are finding it difficult to make the numbers pencil out for office projects in the suburbs, and that is keeping a lid on supply. Burkhardt notes investors can buy suburban assets below replacement cost, invest in renovations and sell the assets, all below replacement cost with a reasonable investment return if they believe in tenant demand.
Part of the increase in suburban property transaction activity is value investing. “You do have some investors that are looking, and even though the transaction volume has been rising, pricing has not increased,” says Lee Menifee, managing director and head of Americas investment research with PGIM Real Estate. “There’s still a huge cap-rate spread between the CBDs and the suburbs. When you can get a 130 basis point or more spread by investing in the suburbs versus the CBD, you end up attracting a fair bit of capital. That’s the first part. And then the second part is that, in some of those suburban areas, you can get comfortable with the basis because there’s really not much being built in them.”
Historically, the constrained areas were downtowns and the unconstrained areas were the suburbs. “That’s been turned on its head in this cycle as the downtowns have become very development friendly, and it’s the suburbs that have really been the restricted development areas,” says Menifee.
Burkhardt notes financing is not really available for suburban office development. “Coming out of the downturn, it was far easier for lenders to finance large developers staying in major markets — beautiful CBD, glass curtain wall, highly amenitized buildings — than it was to ever consider bland, commodity, suburban office building,” says Burkhardt.
Turning around
“The urbanization trend for most of the country is very real,” says Brandon Huffman, portfolio manager with Rubenstein Properties. “It’s been occurring for the better part of a decade now in most MSAs. The question we ask as investors is: Is the pricing ahead of that trend or behind that trend?” Huffman argues a lot of CBD office properties are now overpriced relative to the fundamentals.
“A lot of that product in the urban areas is priced as if the millennial shift to the urban areas is a secular trend and not a cyclical trend,” says Huffman. “It’s as if it’s never going to reverse.” But, he says, the shift toward urban core property in the past five to 10 years is a cyclical change, not a structural one, and we are in the midst of a reversal of the cycle.
“From the 30,000-foot view of the world, is the millennial shift toward the urban areas secular, or is it transitory? In our view, it’s transitory. I don’t think a secular shift is supported by the data. In fact, I think the data supports that the pendulum has already started swinging toward the suburbs over the last 18 to 24 months,” says Huffman.
Suburban office prices have begun to increase. In August, suburban office prices rose 1.6 percent from the previous month and 9.0 percent year-over-year, according to Real Capital Analytics’ U.S. Commercial Property Price Indices, while CBD office prices increased 0.2 percent in August and 3.9 percent from one year ago. But while downtown office values are up one-third in the past decade, suburban office values have not yet reached their prior peak, recorded in August 2007.
“The suburban turnaround is due to many factors, including: one, suburban properties can offer much lower occupancy costs because urban office rents and ancillary costs have increased dramatically in this cycle; two, tenants that desire to expand, and space is not available in urban locations; three, tenants that desire to be closer to home to avoid traffic without giving up access to public transportation; and, four, tenants that desire to create a unique, differentiated sense-of-place for their operations and for recruiting,” says Corbett.
“Despite questions surrounding whether suburban office was in a secular decline, we have held the view that it was simply experiencing a slower recovery; one that will involve a natural reversal in the flight-to-quality trend we saw following the global financial crisis,” says Bobby Ghiselli, managing director, Ascentris.
Another factor pushing up activity in the CBDs, possibly to the detriment of suburban property, has been foreign investors, who have focused pretty exclusively on the center cities of major gateway markets. “The mandates of a lot of the foreign investors in the country recently — including the vast majority of the sovereign wealth funds — only allow them to invest in urban areas. As a result, you’ve seen massive capital flows into all the gateway cities and, in some urban areas, into urban areas of some secondary cities, as well,” says Huffman.
It takes a village
Suburbs have been out of favor for so long, opportunities are beginning to arise. But the types of properties most successful in the suburbs are those that take the best of an urban area and transplant it to suburban environs. These new suburban success stories are mixed-use and walkable, with entertainment and restaurant options.
“As millennials move back to the suburbs to raise families, they will look for locations that can best replicate urban living while providing the housing, social and educational necessities that the suburbs can provide. Suburban locations with convenient access to mass transit will be highly desired. Town centers with high walkability and a sense of community present a microcosm of the urban neighborhoods millennials will be relocating from. Self-contained amenity packages will be less important than the locational amenities of being in highly convenient and interactive suburban neighborhoods,” says Jay Martha, head of multifamily investments at TH Real Estate.
A lot of mixed-use communities popping up in the suburbs are trying to accommodate a “quasi-suburban living,” explains Burkhardt, for people who want to live in the city, with the best parts of city living, but also want the conveniences of the suburbs. “You want to have a cool flat, and you want to have great restaurants, and you want to be able to have somebody to mow your lawn. And so you may not be ready to buy a house in the suburbs, but you can rent a cool apartment in a mixed-use community that has restaurants and bars and places to brunch,” says Burkhardt.
In addition to office and residential opportunities, the suburbs also have retail investment possibilities. There, too, mixed-use is preferred. Traditional retail, especially big-box retail, is going through a major overhaul, and suburban shopping centers are not as appealing as they once were.
“Our preference is retail that interacts with either apartments or office. Ideally, both would be the best. This provides a center with some combination of good daytime and nighttime population, which works very well for retail. We’re focused on the areas of retail that are doing fairly well, which is restaurants and experiential retail, as opposed to retail focused on selling people more goods,” says Menifee.
The most attractive suburban opportunities, across property type, are amenity-rich. That means walkable retail and restaurants, as well as transit options such as light rail. It means density and an “urban village” feel instead of suburban sprawl.
The other key factor for investment, especially residential investment, says Menifee, is very good public schools. “You don’t necessarily need those amenities if you have access to those extremely good schools,” he explains.
“We believe suburban office properties to be an attractive investment opportunity today. But it is important to focus on those properties that are differentiated from other suburban office stock. These properties oftentimes offer efficient floor plates that can be easily subdivided, free parking, easy access to public transportation and major highways, and are amenity-rich so that employees accustomed to the ease of access to amenities in urban locations do not feel they are giving up that much by working in a suburban location. We think of these properties as premier suburban office properties, as opposed to just commodity suburban office properties,” says Ghiselli.
Huffman notes Rubenstein Partners is currently investing in standalone, on-campus amenity centers at several of its suburban assets in Northern New Jersey, Indianapolis and Atlanta, to create suburban product catering to modern demand.
Whither the millennials?
If the shift toward urban centers was driven by a perception of a younger generation that wanted to live and work and play in downtown neighborhoods, the suburban resurgence is driven by a new reality. Millennials are getting older and, although they have delayed marriage and having children in comparison with their parents’ generation, they are now following that well-worn path. A majority of millennials already lives in the suburbs, and the majority of household formation in the coming decade is forecast to be in the suburbs, as well.
“Employers’ desire to attract and retain millennials has been driving urban growth, but as that generation ages and marries — albeit later than previous generations — their desire to have a family will impact their decision on where to work. This will inevitably increase the desire for suburban properties,” says Ghiselli.
The oldest millennials — people born between 1980 and 2000 — are now in their 30s, and the millennial population peak is now 27 years old. The median marriage age has increased from 23 years old in the 1970s to 30 years old today, but a Pew Research Center poll reveals 70 percent of millennials want to get married and 74 percent want to have children.
“The drive by millennials to live, work and play in downtown locations is under pressure from the demands of moving forward with the next significant phases in their lives. Marriage and children create a need for increased indoor and outdoor space, and the safety, security, and lower-cost educational opportunities will continue to make suburban living either a necessity or a desired mandate for newly formed households,” says Martha.
The suburban lifestyle — more space, good public schools — was initially popular during the postwar baby boom. And as millennials, who are themselves an echo boom generation, travel the traditional family path, the attractions of the suburban lifestyle are reasserting themselves.
“Certainly the quality and cost of primary education is critical in driving demand for suburban housing. Access to employment and convenience of travel will also drive housing demand. The reality of high housing costs is inescapable and, as a result, the need for more affordable options in suburban markets will continue. Those markets that can offer the convenience of urban living, combined with the lower costs, social and educational experiences desired in the suburbs, will be the winners,” says Martha.
“When millennials are polled, they overwhelmingly favor eventually being in a suburban locale over the urban counterpart. And when they cite the reasons why, it’s the same reasons people have always cited throughout the course of United States history. It’s household formation. It’s cost of living. It’s the amount of space you have. Public schools are a huge factor. Those are the primary reasons that previous generations eventually went to the suburbs, and the same is true for millennials today, according to the research we’ve seen,” says Huffman.
Of course, millennials are not the only game in town.
“The other thing that gets a little lost is discussions about suburbs are always very focused on millennials. The question about downtown is always focused on millennials. Millennials are not a majority of the U.S. population. So I think it’s important to look at other age groups as well, and thinking about where the baby boomers might end up next. The boomers are generally concentrated in the suburbs, and they may be looking for some other options as well, and those options could be in inner cities or in suburban areas with higher amenity bases. So that, to us, also suggests a source of demand,” says Menifee.
The pendulum keeps swinging
“First and foremost, we must not forget real estate is a cyclical business,” says Burkhardt. “We need to be patient and disciplined and not allow ourselves to be lulled into complacency.”
While the past decade has seen investors concentrate their efforts on CBD office towers and urban-infill apartments, that strategy may have topped out. Value investors are turning their attention to suburban properties. Strong absorption and limited suburban development — as well as properties that are trading below replacement cost — indicate more-fruitful opportunities may be outside the city center in the coming years.
Demographics, too, support suburban growth, as millennials enter their prime family-formation years. But they don’t want to live in their parents’ suburbs — their parents may not even want to live there anymore. Instead, urban-like suburban properties — walkable, mixed-use, amenity-rich — are most favored, by millennials and baby boomers alike. Employers will continue to follow employees, occupying space where they can best attract talent.