The Urban Bubble in Commercial Real Estate

According to national headlines, commercial real estate (CRE) is thriving—with observers pointing to high prices and increased foreign investment as signs of recovery. A closer look at the industry, however, reveals a more complicated landscape. While rents and prices are indeed soaring in urban areas, CRE is stagnating or even declining in terms of new investment and in most non-urban sectors. In many ways, the trends we’re seeing today are the culmination of nearly two decades of generationally driven migration pat­terns. Although Boomer youth eschewed cities in favor of rural living, today’s young, high-income professionals want to live and work in urban areas—a shift that is triggering a highly focused boomlet that has left most of the rest of CRE untouched.

Over the past few months, media outlets have been touting CRE’s comeback. Overall prices have skyrocketed—up 93 percent from 2010’s low and 16 percent above 2007’s high. At the same time, investors are flooding the market. By the end of the first quarter of 2015, banks had $1.7 trillion of CRE loans outstanding—just 2.6 percent shy of the record set in the first quarter of 2009. This growth has been accompanied by a flurry of foreign activity. In 2014, foreign investors pumped $45 billion into US CRE—second only to 2007’s $47 billion.

Higher prices and rents in prestige urban areas have attracted the most attention. As we predicted in “The Housing Market’s Slow Train to Recovery,” young, high-income pro­fessionals are fueling growing demand for multifamily units. Commercial property price indexes for apartments are at 294 today—up 180 percent from 2009’s low. Meanwhile, prices of office buildings in central business districts rose 115 percent to 245 in the same period. Hotels are scrambling to add new rooms for business travelers. (See: “Hotels Earnings Are Up—but for How Long?”) In some cities, it’s hard to keep up. New office space construction in Manhattan, for example, was projected to reach 4.3 million square feet in 2015—a 79 percent increase from 2014 and the highest level in 25 years. No wonder the commercial media are celebrating the return of CRE: It’s all happening in their backyard.

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But the market booms in the down­towns of Boston, Los Angeles, Dal­las, and Atlanta don’t reflect the state of the CRE sector as a whole.

First of all, a look at CRE by prop­erty type reveals that most of the good news is restricted to multifamily units, downtown offices, hotels, and a couple of specific manufacturing struc­tures. Invest­ment in natural gas infra­struc­ture (main­ly pipelines to harness America’s recent shale-gas bonanza) is skyrocket­ing. Railroad capex has also shown strong growth. But in most other property types, not much is happening. The vast majority of manufacturers, hard-hit by the rising dollar, are cutting back. More broadly, in the industrial sector, commercial prop­erty price indexes have pla­teaued—hardly a surprise consider­ing industrial production has declined over the past four months. Energy compan­ies have shut down more than half of all their oil rigs and slashed the number of gas rigs to their lowest level in 28 years. In 2015 alone, three major mining compa­nies declared bankruptcy.

Outside the industrial sector, decline is widespread. According to Cen­sus data, the growth rate of spending on health care construction has fallen over the past six years. Higher education is also paring back now that the demographic high tide of Millennials has graduated. Meanwhile, in the public sector, the dollar value of construction still hovers below its 2008 peak. Federal, state, and local governments cut nonresidential spending by 17 percent from 2008 to 2014—and defense capex (not measured by Census) has been in free fall as well.

The recent CRE boom has also been highly regional: It’s mostly urban, with little effect on suburban and rural areas. While commercial property indexes in the six major metro areas have far exceeded their pre-recession levels, their counterparts in non-metro areas are nowhere near their previous high. This dichotomy is most apparent in small towns and rural areas, where people and commerce are exiting and prices remain depressed. In the suburbs, 18.3 percent of office real estate is vacant. That’s a full five percentage points higher than in cities.

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Finally, the recent CRE excitement is generated more by higher prices than higher investment. According to the Construction Spending Survey, overall investment in new commercial construction hasn’t reached pre-recession levels. Indeed, prices would not be climbing so high if there were more investment—but it seems that many high-prestige urban areas are placing a low ceiling on new construction. Either no available real estate or tight zoning restrictions (or both) are causing investors to bid up rents and prices of existing CRE rather than build new CRE.

So what has spurred this highly focused urban boom? Over the past fifteen years, cities have steadily become the preferred locations to live and work—particularly for Millennials. The historical norm since 1900 is that Americans move briefly to cities to work as young adults and then, gradually as they raise families, return to suburbs and rural areas. But this phase-of-life migration pattern bends according to the preferences of each new generation. Young Boomers were so attracted to rural America that they ushered in a rare decade (the 1970s) in which rural growth actually exceeded urban growth (see: “Hard Times in Rural America”). But Millennials are bending in the opposite direction: Today’s cities are much younger relative to the population of their respective states than they were a decade or two ago. As goes the best and brightest of the rising generation, so goes the demand for the structures in which they sleep, work, and play.

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Much of this newfound attraction to urban life (which began ramping up in the 1990s with young Xers) has a generational explanation. Young Boomers steered clear of cities when youth crime was rising; young Millennials see no problem joining the urban workforce at a time when youth crime is falling. Another difference is financial feasibility. Between low salaries and high student loan debt, many Millennials can’t afford the sub­urbs. Cities also appeal to the Millennial mindset. This generation craves the close connections that dense, walkable communities can foster.

Looking ahead, the commercial real estate market has several good years on the horizon. The largest birth cohort of Millennials (now age 25) is just entering the workplace. Over the next five years, they’ll continue to boost demand for urban communities. In crowded areas that are heavily zoned, prices may inch ever-higher. And if developers can’t demolish old structures to make room for new ones, both developers and small businesses may have to expand into the inner suburbs and second-tier cities to accommodate the late wave of this generation (and for the first wave as they start families). One way or another, young Millennials will find the blended urban atmosphere so many of them seek.