Do Bond-Market Vigilantes Exist?

By Bob Bach, Grubb & Ellis Inc.

One of my colleagues at Grubb & Ellis recently wrote the following: "From a longer-term perspective, look for investment capital to flow to those states that optimize the blend of balanced budgets, low taxes (property, income and sales), low regulation and business incentives. Businesses and people are more mobile than ever, and intelligent capital will go there first." This is an intriguing concept, but is it true?

One of my colleagues at Grubb & Ellis recently wrote the following: “From a longer-term perspective, look for investment capital to flow to those states that optimize the blend of balanced budgets, low taxes (property, income and sales), low regulation and business incentives. Businesses and people are more mobile than ever, and intelligent capital will go there first.”

This is an intriguing concept, but is it true? Will commercial real estate investors choose low-tax, low-regulation states like Texas over high-tax, high-regulation states like California and New York? The data so far are inconclusive. According to Real Capital Analytics, the dollar volume of transactions in 2010 versus 2009 increased by 192 percent in the New York City metro area, 162 percent in coastal California and 185 percent in the major Texas metros (Dallas-Fort Worth, Houston, Austin and San Antonio). In terms of the number of deals, however, Texas handily beat the other two regions, increasing by 129 percent last year versus 73 percent in greater New York and 91 percent in coastal California.

Another way to look at this is by the average deal size, which increased last year by 69 percent in New York (from $17.9 million in 2009 to $30.2 million in 2010), by 37 percent in coastal California (from $17.3 million to $23.7 million) and by 24 percent in Texas (from $14.6 million to $18.1 million). These would be for transactions greater than $5 million, the minimum size threshold tracked by RCA.

This makes some sense. Investment capital flooded into coastal markets in search of core assets last year – in other words, the very best properties in the markets with the strongest prospects for rent growth. Texas and many other middle-American markets don’t fit this profile due to low barriers to entry. But Texas has strong job growth prospects, and with the smaller average transaction size, the Texas metros appear to be attracting smaller private investors looking for bargains.

It’s tempting to think there might be commercial real estate market vigilantes in the mold of bond market vigilantes, i.e. ready and willing to pull their investment capital from states and localities that overtax, overspend and over-regulate. But New York and California appear to be at least holding their own compared with Texas. Nearly all states with the exception of Alaska, North Dakota, Montana and a few others – hardly magnets for investment capital – have severe budget problems, and most newly elected governors, whether Republicans or Democrats, are singing from the same hymnbook, the song of cutting spending while keeping taxes low.

The moral of the story: Investors are willing to give states the benefit of the doubt if those states offer other reasons to invest such as job and population growth and supply constraints – at least so far.