Growing Office Returns in Growing Cities March 5, 2019 Chuck Schreiber Providing stable, long-term returns for investors depends on a number of factors, two being investing in growth markets and controlling costs. If rents are rising because the market is thriving, and if costs are lower than similar investments, the asset has potential to perform at or above expectations. But what makes a growth market? And how do you reduce acquisition and operating costs? And if it’s all that easy, why isn’t everyone doing it? All good questions. Let’s start with what makes an attractive growth market. The gateway cities — Boston, New York City, Washington, San Francisco, Los Angeles and Chicago — have a well-deserved reputation as solid choices for the office investor. However, competition and constrained development have made these markets pricey. Cap rates in the office sector are so low in some of the most popular cities that it is difficult to see how anyone can meet yield expectations after all acquisition and management expenses and fees are netted. Partly because of these high prices, compressed cap rates and competition in gateway markets, interest in secondary markets is picking up. But the uptick in interest isn’t all about pricing. The trend is being driven as much, if not more, by a millennial workforce choosing more cost-efficient places to live. By 2020, it is estimated nearly half of all workers in the U.S. will be millennials. It is not a cohort to be ignored. As such, employers are following the talent and also moving into these mid-sized cities. For example, Honeywell has announced that it is moving its headquarters to Charlotte from New Jersey. Nissan’s North American headquarters is in Nashville. Portland, Ore., is becoming a tech mecca. According to Emerging Trends in Real Estate 2019, 17 of the top 20 growth markets are non-gateway markets and are expected to outperform the national average in population, employment and rental growth in the next year. In fact, non-gateway markets outperformed gateway markets in rent growth last year (3.4% vs. 1.2%, respectively), according to Cushman & Wakefield. What makes these particular cities attractive to millennials and the companies they work for? After all, there are lots of mid-sized cities in the country. What makes Austin, Seattle, Nashville, and Denver so special? Educated populace — Educated people like to live with and interact with other educated people. Corporations that value this education—particularly tech, finance and healthcare — find themselves relocating to take advantage of the talent. In addition, cities with a large university presence are finding that local graduates are staying and starting their own businesses, providing a thriving entrepreneurial culture. Walkable core — Young workers are abandoning their cars. They want to be able to walk to work, the store and social events. Well-defined city cores are, therefore, more attractive than sprawling metro areas. Good public transport — One of the prime indicators of a growth market is a light rail system. Millennials, in particular, want shorter commutes and good public transportation. Light rail systems are an indication that a city can provide both. Interesting social life — Upscale restaurants, cultural events, thriving arts & music scenes, museums, sports teams and varied entertainment are the lifeblood of a growing city. The educated population that makes up these attractive markets tends to live and work downtown or close-in urbanized suburbs. They want a social life that matches the stimulation of their work life. Companies moving in – A growth city has diverse industries, so if one sector is slowing, another is there to pick up the pace. A sign of this diversity is companies relocating to the area. You rarely hear of corporations relocating to New York City, but you often hear of them moving to cities such as Denver, Seattle, Austin and Charlotte. Pinpointing growth cities, however, is only half of the equation of realizing attractive returns. Controlling costs is just as important. Buying new Class A buildings, even in non-gateway cities, is expensive. New development can be risky. But refurbishing existing buildings in great locations can be a way to control cost while offering upside potential for the investor. Acquiring 20- to 30-year-old Class A assets in these markets is one way to go. But those who had the foresight to move into these markets early, and thus already own buildings in these recently-popular metro regions, start off with a real advantage. They don’t need to buy and then refurbish. They just need to update and add the amenities required to make the new workforce comfortable. Some of the most requested amenities include gyms, a variety of shared conference spaces, lobby coffee shops, and even bike and skate board racks. HVAC upgrades to make the buildings more sustainable not only help the investor control costs but satisfy workers who want to work in green spaces. Now, if all you have to do to select one of the top growth markets in the Emerging Trends list and then refurbish an existing building to achieve great returns, why isn’t everyone doing it? Because it’s not as easy as it sounds. Knowing what to look for is one thing. Being able to execute is another. Owner/operators with a deep understanding of local markets are much better positioned to know the best locations and to be able to choose the right office buildings to refurbish. They know that even in hot growth markets, some neighborhoods and buildings are better than others. They know what drives rents within specific neighborhoods. They know the local population and which amenities will be most attractive, so capital is not wasted on items the tenants don’t care about. All of this means that selecting the right smart city to invest in is just the start. For investors who want a better chance of meeting return expectations, selecting a real estate sponsor who understands the market and has hands-on experience managing and adding value to acquired assets may be the right way to go. Chuck Schreiber is the CEO and co-founder of KBS, one of the leading office owners in the United States with more than $11.0 billion in assets under management and a transactional volume in excess of $38 billion.