Economist’s View: You Get What You Pay For

A small set of densely populated cities with strong agglomeration economies have proven to provide investors with superior risk-adjusted returns over the past quarter century. Here’s why.

When I last closed this column, in the September issue of Commercial Property Executive, I noted that a small set of densely populated cities with strong agglomeration economies have proven to provide investors with superior risk-adjusted returns over the past quarter century. I promised that I would present some of the reasons why in this month’s column. So here goes.

The set of high-performance markets includes some of the nation’s largest metro areas—among them New York, Chicago and Washington, D.C.—but also cities of considerably smaller size, like Boston and San Francisco. Size is not the only factor, to be sure. Some large metro areas—Los Angeles, Houston and Atlanta, for instance—have had high- growth economies and yet have only middle-range or even lower success in giving investors satisfactory in- come and appreciation returns on capital committed to commercial real estate.

One of the basic features of America’s economic geography is the disproportionate concentration of the factors of production: labor, capital and real estate. Remembering that there are more than 300 metropolitan areas delineated by the Federal Office of Management and Budget, it is remarkable that the top 10 metros (about 3 percent of the total number) account for 20 percent of the U.S. population and 23.7 percent of our gross domestic product. There is a lot of resentment of big cities around the country, both from the Occupy Wall Street crowd on the left and the Tea Partiers on the right. But the nation’s prosperity is generated by our great cities. That is indisputable.

What accounts for this? And what difference does it make for real estate?

Density counts. But there is good density and bad density, just as there is good cholesterol and bad cholesterol. Taking the metro level for comparison purposes, population density per square mile in New York is about 6,600; in Boston, 1,400; and in Chicago, 1,200. Los Angeles is also strong at 2,000 per square mile, but Atlanta is just 662; Dallas, 542; and Phoenix, 223. The spread-out nature of the latter cities has many consequences, some good and some bad. Low density means weak land value, all other factors held constant, and consequently lower real estate prices generally.

On the other hand, greater density has positive consequences for efficiency. For one thing, it is easier to get around in dense areas. The marvelous Web site rates cities and neighborhoods on the network of retail facilities, public amenities and recreational opportunities “within walking distance.” On a scale of 1 to 100, San Francisco scores 86; New York, 83; and Boston, 79. L.A. is much less walkable, with a score of 67, while Dallas and Phoenix are far down the scale at 51 and 50, respectively. Unsurprisingly, this is highly correlated with the incidence of walk-to-work housing near the CBDs of the cities, which is in turn a factor in the greater number of hours worked per person in the higher-density cities.

Commercial real estate ultimately is paid for by property occupants’ profits. Hours worked is suggestive of productivity, but output per worker—measured in dollars—is perhaps a more direct indicator. Data from Economy. com provides gross metro product for each metropolitan area, a figure that when divided by the number of workers measures output per worker. Again, the contrasts are striking. New York leads with $138,900; San Francisco is close behind with $134,600. Los Angeles has a solid $129,400, close to Houston’s $129,500. Dallas is off the pace at $110,000, Atlanta is close to the national average at $103,500 and Phoenix lags the U.S. norm at $98,500.

Jane Jacobs long ago postulated that “eyes on the street” were a significant deterrent to crime
and that dense city core areas contribute to urban safety. The data appear to bear that out. New York’s citywide crime rate (from the FBI’s Uniform Crime Statistics program) is 2,432 per 100,000 population, Boston has a crime rate of 5,308 and Washington, D.C.’s is 5,330. All are below the average for cities with populations above 250,000 people—the categorization of “largest cities” used by the Federal Bureau of Investigation. Atlanta (8,910 crimes per 100,000), Dallas (7,845) and Phoenix (6,550) have much higher crime rates. Businesses and investors surely take notice of such differences.

In an era when riskiness is heavily discounted by investors, the volatility of economic performance is a variable priced into investor behavior. Using employment as its bench- mark, calculates the cyclical volatility of the metro area. Using a standard of 100 for the United States as a whole, Washington (85), New York (97) and Boston (98) are among the least volatile of large U.S. markets. L.A. (118) has moderately wider swings than the nation as a whole. Atlanta and Dallas have much greater ups and downs, with both scoring 143 in’s analysis. Phoenix (219) has more than twice the national volatility, a true boom-and-bust record.

So when investors seek to place their capital into the commercial property sector, it is hardly surprising that they prefer the denser, more productive, physically safer and less volatile urban areas. Such cities have provided measurably higher risk-adjusted returns over the past 25 years, and so command consistently higher prices for income-producing property assets. Interestingly, the same is true for the performance of housing assets.

Washington, D.C., led the 20 home-sales markets tracked by the Case-Shiller Index, at 187 as of August 2011 (with prices benchmarked to a 2000 norm of 100). New York and Los Angeles were about even at 169, and Boston was a strong 156. Dallas was tepid at 117, with Atlanta (102) and Phoenix (100) showing no appreciation at all over the past 11 years. Thus, homeowners have had investment results remarkably similar to commercial property owners since the turn of the millennium. This is, I believe, a sign of fundamental socio-economic differences in the cities themselves.

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