Top Targets

Experts identify the best and worst cities for investment.

Experts Identify the Best and Worst Cities for Investment

By Suzann D. Silverman, Editorial Director

With real estate remaining a preferred asset class, all manner of investors continue to seek property in which to place their capital. That drove investment sales volume to $145.3 billion in the first half of 2013, up 24 percent over the same period last year, according to Real Capital Analytics Inc.

The increase came as a bit of a pleasant surprise, since investors were rushing last year to complete deals before the new year brought a rise in capital gains taxes. But the momentum carried over into 2013, and even the May increase in the 10-year Treasury and June interest rate hike did not stop it. The second quarter saw $71 billion in sales of significant commercial properties, an increase over second quarter 2012 despite a slowdown in the previously leading apartment sector. And with both equity and debt players still energetically vying for deals, RCA managing director Dan Fasulo expects the second half of the year to be big. “It’s the most diverse group of players I’ve ever seen in my career, and it’s created massive liquidity,” he said, predicting the return of the big deal this year.

The investor base may be diverse, but the reasons for selecting markets are not. The overarching theme is employment. “Follow the jobs, follow the growth, follow the employment,” advised Jones Lang LaSalle Inc. director of research for the capital markets Marisha Clinton. But jobs alone are not enough: Quality counts, and the fact is that while the employment market is improving, many of the jobs that have been added are low wage, noted Milken Institute chief research officer Ross DeVol. For that reason, when the Milken Institute ranks markets, it considers wage growth as well as employment growth.

There are in fact currently just a few main drivers of quality job growth: The strongest markets today are largely those with solid bases in technology, energy and, to a growing extent, housing. Last year, researchers and investors also included education and healthcare on that list. While the aging population has attracted many real estate investors to the healthcare sector, it has lost its steam as an economic growth engine, according to DeVol. “In the midst of the most severe recession in the post-war period, a large concentration of healthcare provided stability to many communities and didn’t experience the decline in employment. But now that we’re coming into the recovery phase, they’re not adding jobs at the same rate they had been in past years, so that’s played a lesser role on the healthcare services side,” DeVol explained. And he does not consider education itself an economic driver but rather a further contributor to job growth in the big technology centers.

At a broader level, while the economy is improving, too much uncertainty remains, with both the slow jobs recovery and sequestration feeding into it—not to mention the hiccup in the financial markets this spring. That response to the bond market’s increase and the interest rate hike following comments from Federal Reserve chairman Ben Bernanke will likely result in “a bit of a wait-and-see around the secondary markets,” where loans are largely the domain of the CMBS sector, predicted Jones Lang LaSalle president of the Americas Capital Markets Jay Koster. But while CMBS flow has slowed, Clinton expects it to remain “quite strong,” following an issuance volume of $45 billion in the first half of 2013, versus $48 billion for all of 2012—which was already a post-recession high.

“(CMBS) is going to have a good year this year,” observed Fasulo, also pointing to growing activity among both local banks and insurance companies.

Markets noted for their technology bases have particularly proven their ability to recover, having been hard hit during the recession as companies cut back on orders for IT equipment and services and startup rates slowed due to reduced access to capital, noted DeVol. Their situation is far different now. In fact, according to analysis for the Milken Institute’s “2012 Best Performing Cities” study, released in January 2013, among the top 25 cities on the list were 12 that are considered strong technology centers, topped by San Jose, which catapulted from a 51st-place ranking last year. (See “Top Markets” on page 29.)

The energy sector has also continued to expand. Energy growth has come from both exploration activity and the controversial fracking phenomenon, which has favorably impacted metropolitan markets close to rural shale outcroppings where these efforts to mine natural gas and petroleum are taking place. The Texas markets are performing well, including not only Houston but Dallas-Fort Worth, San Antonio and El Paso. (Austin continues to perform strongly as a technology city.) In addition, North Carolina, Colorado, New York, North Dakota and parts of West Virginia are all benefiting, DeVol noted—and even some of the Midwestern metros are starting to experience positive effects. There are also some more remote beneficiaries, such as Bakersfield, Calif., which provides steam injection services for oil wells.

Recovering housing markets are now attracting investor attention, as well, although it is too soon for new construction, DeVol noted. Those that were hardest hit—including California, Florida, Nevada and Arizona—have largely worked their way through their oversupply and have stabilized, he said. And PricewaterhouseCoopers real estate advisory practice leader Mitch Roschelle expects them to continue to recover, with a ramp-up in homebuilding also driving commercial improvement because of the prevalence of related professions—such as attorneys and architects—as office building occupants. “Those markets are in varying degrees of roaring back,” he said.

And as the jobs return, that is attracting more young people. “If you look at the jobs that really existed in many areas of this country prior to the collapse,” he observed, “a lot of them revolved around homebuilding, and with the homebuilding industry well into its recovery, I think there’ll be continued job creation there.” He added Colorado to the list of states that are benefiting, noting that more young people are remaining in and around Denver and Boulder after they graduate because of the greater number of available jobs.

As investors seek to capitalize on market growth, they have two options: Pay higher prices and accept a lower yield in more established markets or seek greener pastures. Indeed, while REIS Inc. senior economist Ryan Severino last year predicted overall returns in the 8 to 10 percent range, this year he expects them to be “somewhere below” that level. And popular Manhattan is netting yields below 4 percent, noted Fasulo.

Even so, many institutional investors still prefer to stick with the gateway, or 24-hour, cities or select larger secondary markets—which some call “primary secondaries.” They include those supported by growth industries or sufficiently diversified that they will remain buoyed despite the economy’s dips and shifts—the likes of Austin, Dallas-Fort Worth, Houston, Seattle, San Diego and other growth markets.
Smaller—so-called tertiary—cities largely remain the purview of private investors and those willing to take on greater risk in exchange for reduced competition, such as second-tier REITs and smaller institutional capital, noted Christopher Ludeman, president of the capital markets for CBRE Group Inc. However, larger institutional investors will consider good opportunities regardless of where they are located.

“If it is the right opportunity, they may actually look at a city that they would otherwise not have looked at,” noted Greg Vorwaller, global head of capital markets for Cushman & Wakefield Inc. When they do purchase in a smaller market, though, they are limiting themselves to better-quality properties, higher-credit tenants or both, noted Clinton. Or the property may be part of an institutional-quality portfolio.

Roschelle noted a shift to secondary markets that promise growth—and especially those with a high percentage of people in the 25-to-35-year age range. But Clinton cautioned that while secondary markets continue to maintain a sizable share of real estate investment dollars, the growth somewhat stabilized during the first half. Market share then totaled 43 percent for overall office investment, for instance, up from 42 percent in all of 2012 and 38 percent in 2010 and 2011. (In pre-recession 2007, they netted 41 percent of market share.) That compared to 53 percent for primary markets in the first half, versus 52 percent in 2012.

Severino likewise remains cautious regarding investment in secondary markets, given that the recovery in real estate fundamentals is still a year or two away, he noted.

Foreign investors are still largely focused on the gateway cities, with New York, Los Angeles and Chicago ranking among the top 10 cities for investment worldwide, according to a Jones Lang LaSalle report. But the report found growing interest among foreign investors in U.S. secondary cities this year as yields grow tighter in customary markets, including a Canadian interest in Seattle and a broader Middle Eastern interest in U.S. hotels.

Even so, foreign players remain a small percentage of the U.S. investment market, as interest grows in the European market and real estate groups lobby to relieve the constraints of the Foreign Investment in Real Property Tax Act. “We’re getting only a fraction of the foreign capital we could be getting. … Who knows how much additional capital we’re leaving on the table,” Fasulo speculated.

This article appeared in the September 2013 issue of CPE. For the full article, including multiple charts depicting key investment data, see “Top Targets.”