The Shift to Non-Gateway Markets
In this time of unprecedented change caused by COVID-19, the commercial real estate industry has emerged with both “winners” and “losers” as sectors rush to adapt to reactive preference changes. Slow-moving trends and ideas that have long been speculated in the estate industry are suddenly coming to light with the instability of the market. In the months that have followed the spread of this global pandemic, we have experienced detrimental economic disruption – cities once deemed the most successful, stable, and profitable are now filled with stranded assets. From this global disruption, the argument for non-gateway markets is stronger than ever before.
The commercial real estate industry recognizes its most prominent, innovative projects in what are known as gateway markets, or primary markets that include cities such as New York, Boston, Chicago, Los Angeles, Washington, D.C., and San Francisco. For years, these markets have been targeted as elite space for development based on their global reach. Through long-standing reputations, gateway markets have retained an advantage over secondary and tertiary markets; they hold the largest populations in the United States, offer plenty of opportunities, and are home to the largest, most influential companies. Innovation finds a home in these cities. Quoting a BISNOW article from October 2019 titled “It Just Sounds Good,” Cameron Sperance writes, “population and economic ranking don’t always dictate a city’s business climate, but for many leading developers and investors in commercial real estate, ranking means everything.” Citing a herd mentality, gateway markets get the investors on board. This was made explicitly clear in the article by Eric Sussman of Clear Capital LLC, stating, “it’s perception… I may well know the upside is better in [secondary market], but some investors are going to say no to investing in tertiary or secondary markets.”
It’s evident these gateway cities exude stability that gains trust. While non-gateway markets offer a level of risk that can pump a deal with greater returns, most end up following the major trends in major cities to play it safe. Unfortunately, gateway markets no longer hold this “safe” title because of the COVID-19 pandemic. Following the shutdown of major cities across the United States, many employees have been forced into remote working. This has drawn residents from gateway cities into popular non-gateway cities – at least for the duration of remote employment. Bloomberg City Lab reports that there has been an exodus of residents from the United States’ largest, densest, most expensive coastal cities, such as San Francisco and Manhattan. Of those residents to move, permanently or temporarily, during the pandemic, 18-29 year olds make up the largest group. An excerpt from the BCL article:
“‘In many metros what we’re seeing, and it’s early in the days that we’re seeing that, is that there are indicators of more demand for the less expensive, further out inner suburbs as opposed to the central city of metros where we’ve seen growth in jobs,’ said Susan Wachter, professor of real estate and finance at the Wharton School of the University of Pennsylvania. ‘That’s what was happening even before Covid,’ she said, referring to population growth rates in the suburbs and exurbs that have been speeding up over the last several years.”
Although many have argued the movement into non-gateway markets is simply a short-term solution during the pandemic, continuous development and investment in these areas, and delays in vaccine development may be the combining factors that could convince visitors to stay. With the growing retention of top talent and work/play environments offered at a lower cost of living, secondary markets may sway an increasing number of young potential residents. For the investor, the global pandemic has exposed holes in the gateway market system. Migration out of these cities and remote working reinforce the existence of greater economic sensitivity in these areas. For many companies located in gateway markets, remote work has destroyed the notion that a “well-located office building full of highly paid workers in or near a dense, expensive city is the best way to operate a successful firm,” says Danny Ismail from Green Street.
From the start of the pandemic, the top U.S. office markets have been in freefall: in Q1 and Q2, leasing volume was down 20.8% and 53.4%, respectively. Year-over-year, this comes out to a whopping 44% decrease in leasing activity. As the United States enters its recovery phase, major questions remain: will gateway markets return to the powerhouse they once were? How many people will remain in their “quarantine locations” long after remote working ends? How many companies will stay remote, compress their locations, or move out of the gateway entirely? Workplace uncertainty bodes well for non-gateway markets. Even before the pandemic began, many sources reported that long-term office trends favored non-gateway markets for their growing pools of young talent and greater returns, especially in the Sunbelt. In a report title “The New Normal,” KKR’s director of global macro and asset allocation, Paula Campbell Roberts, writes:
“Covid has only accelerated the growth of medium-sized cities, as well as exurbs and suburbs near gateway cities. Amid growth in southern and medium-sized cities nationally, the locus of economic activity should disperse among multiple metropolitan nodes beyond gateway cities.”
The influx of young employees to non-gateway markets has created a ripple effect, with many major companies opting for an employee base in these locations. Nashville, for example, is one non-gateway market that is becoming an increasingly popular location. Amazon has added 1,000 new jobs – of the projected 5,000 – for its new logistics hub in the secondary market. AllianceBernstein has also moved into the area, and it’s expected that 1,250 employees will move to the area by December 2024. Cary, North Carolina, is another great example of a non-gateway market. Within the North Carolina Research Triangle, this emerging market has both technology infrastructure and a strong higher education backbone to pull talent into the area. One project that will further talent attraction in Cary is a 92-acre Hines-led development. This walkable district will provide a work/play lifestyle through 200,000 square feet of office space and residential offerings and will include retail, hotel, and entertainment space. With the injection of young talent into these markets, non-gateway cities offer greater returns that make them more attractive. Jeff Shaw from Pensions & Investments writes, “Investors may view secondary market asset pricing, which is often significantly below replacement cost, as a comparative bargain to gateway markets and as an opportunity to secure yield. Assets that meet return thresholds are now simply less available in gateway markets.”
However, the overall buy-in for these cities has yet to stick. Most investments in these markets remain selective. By reputation, these areas seem more volatile and therefore less predictable – returns change by industry and by city. These markets also lack the barriers to entry you regularly see in gateway markets, which leads to overproduction.
In this time of extreme uncertainty, it would be ludicrous to predict the future of the commercial real estate industry accurately. However, it’s important to note the unlikeliness of trends to revert to their pre-COVID standing. The coming months will be vital in understanding which trends will be solidified in the industry, as many employees are set to return to work, and a vaccine is set for distribution to the public. Looking ahead to the end of the pandemic, we must consider the transaction-related risk in gateway markets, as well as employer decisions to remain in these cities.
By: Annie Ullrich