Economist’s View: What’s Your Bet: Car or Elevator?

While some favor the low-density, suburbs-focused model of construction, there is still much to be said for the vertical constructions of city centers in terms of CRE investment. All other things being equal, urban development typically brings a much stronger return. By Hugh F. Kelly.

Frank Lloyd Wright (1867– 1959) is one of the iconic figures in the American imagination. He is famously known as the model for Ayn Rand’s hero, Howard Roarke, in The Fountainhead. His designs earned him the accolade “the greatest American architect of all time” from the American Institute of Architects in 1991. His notable work includes New York’s Guggenheim Museum, the Price Tower in Bartleville, Okla., and the Johnson Wax headquarters tower in Racine, Wis. All are listed as national historic landmarks.

But Wright is better known for his low-rise construction than for vertically oriented buildings. He believed in low-density communities, and developed a model called Broadacre City in the 1930s that was based on the expectation of universal automobile ownership. Wright once said, “The outcome of the city will depend upon the race between the automobile and the elevator—and anyone who bets on the elevator is crazy.”

For much of the 20th century, Wright’s prediction looked dead-on. The nation’s fastest-growing places were car-based cities in the South and West, and the equally automobile-dependent suburbs surrounding the nation’s older northeastern cities. The high-density, high-rise downtown served primarily by mass transit was often derided as a “dinosaur.”

Authors such as Joel Garreau and Joel Kotkin still favor the low-density model, noting that suburbs and the Sunbelt continue to outpace central cities and the Frostbelt in population and employment growth. Kotkin’s “newgeography.com” site ranks Austin (1), Raleigh (2), Dallas (7) and Phoenix (8) ahead of New York (35), Boston (37), San Francisco (42), and Chicago (47), based on future prospects. In these rankings, the latter set of higher-density cities are ranked lower than Baltimore (21) and Kansas City (25) and are mixed in with cities like St. Louis (34), Pittsburgh (39), Hartford (44) and Detroit (50).

Can This Be Right?

First, let’s acknowledge that on average the tendency for American cities to sprawl out toward the perimeter and for the urban core to “hollow out” is a fairly accurate description of metropolitan trends. Many—probably most—U.S. metro areas follow this pattern. Journey-to-work data from the Census Bureau shows the unremitting preference for automobile commutation, which is how more than 85 percent of us travel to our jobs, adverse environmental impacts notwithstanding.

Second, let’s stipulate that if growth is the measure, then it is hardly surprising at all that younger cities outstrip older cities. Organically, growth is a function of youth: Teenagers grow faster than their parents, as a rule. For urban areas, there is something of a denominator effect, too, since the younger metros also tend to be somewhat smaller. So a given number of new residents or new jobs will yield a faster growth rate in a younger, smaller city than in an older, larger city.

Many real estate professionals are in accord with the argument thus far, and consider faster growth to be a fundamental measure of demand. More rapidly rising demand should, other things being equal, mean a better investment environment over time, according to this logic. Others think, “Not so fast.”

While cities on average display a pattern of growth at the periphery, this phenomenon is not universal. The classical name for a system in which energy spreads out until it is evenly distributed is “entropy,” and that nicely captures the basic post-World War II changes in urban geography. However, there are cities that have shown a tendency to reconcentrate their economic energy toward the core. These cities gentrify their residential neighborhoods, enjoy strong agglomeration advantages among their businesses, provide urban quality of life and are attractive to high-human-capital workers, variously described as “knowledge workers” or “the creative class.” This small set of exceptional cities can be called “anentropic” attracters of energy.

And although growth is clearly characteristic of the young, so are swings in mood and behavior. For cities, this is volatility, or the tendency to boom-bust extremes in cycles. Because of their larger employment and population bases, the anentropic cities have shown more stable patterns—lower-percentage changes up and down in cycles—than the high-growth cities. In biology and psychology, this is called “maturity.”

The demand side of the equation represents only half of the market dynamic. There are also supply considerations to take into account. Many high-growth cities have the advantage of 360-degree expansion opportunities, and consequently an abundant supply of cheap land. This promotes high levels of development, adding substantial new competition to the market. Many of the older anentropic cities have development constraints, either in the form of topography or regulation, that limit new-supply additions.

My research shows that this makes a significant difference for commercial property investors. Compared to a group of high-growth but entropic cities, places like New York, Boston, Chicago and San Francisco have enjoyed cumulative total returns since 1987 that have been higher by 76 percent for office properties at the metro level and by 111 percent for downtown offices, while having less volatility over nearly two-and-a-half decades.

I will explore the reasons for this superior risk-adjusted performance in my next column.

Hugh F. Kelly, PhD, CRE, is a clinical associate professor at the NYU Schack Real Estate Institute.