Commentary: The demographics driving real estate investments in non-gateway cities

Real estate investors have long been attracted to office investments in prime business centers of the U.S. gateway markets, Boston, New York City, Washington, San Francisco, Los Angeles and Chicago. However, there is a demographic shift underway that is driving interest in office investment opportunities in non-gateway cities — a trend that cannot be solely attributed to the high prices and significant competition in most major markets.

Data show the population growth of millennials in non-gateway (secondary) markets has exceeded gateway markets with the trend expected to continue through 2022. This young adult population, age 20 to 34, is in search of well-paying jobs, affordable housing and high quality of life that can be found in prime business centers of non-gateway markets at a more reasonable price. Since jobs follow workers, many of these markets are experiencing employment growth, creating demand for well-positioned, modernized office assets with full amenities that appeal to millennials.

Non-gateway office-using employment growth is 66% greater than in gateway markets. Many employers are finding it difficult to recruit skilled labor in the ever-tightening gateway markets, which are increasingly ruled by large companies that put pressure on small to midsize businesses attempting to attract and retain talent in the same geographical area.

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. In response, investors are casting a wider net for stable yet growth-oriented acquisitions — a trend that should continue in coming years.

While there is appeal to the energy of city living, millennial priorities are changing. They are increasingly seeing value in different things such as a lower cost of living, shorter commutes and better work-life balance, as well as easy access to groceries, the outdoors and startup communities. Millennials are realizing non-gateway cities better align with their priorities, as they offer an abundance of high-quality amenities in both urban and suburban locations and are often more affordable for the average working family. While gateway markets do offer a high quality of life, it is mostly at the income extreme. The development of mixed-use urban and suburban areas in many non-gateway markets is bringing this concept to more millennials at a much more achievable cost.

Investors with a deep understanding of local markets are uniquely positioned to align with the shifting priorities among the millennial demographic and increasingly are focusing on areas in growing markets that offer cultural attractions, walkable cores, premium retail and restaurant offerings and good public transportation options.

A study by the Urban Land Institute showed that 60% of millennials expect to live in a single-family detached home within five years. Almost half of the millennial homeowners live in suburbs, according to research from Zillow. As they search for homes, they will look for urban-suburban locations that provide well-paying jobs and affordable housing in walkable, amenity-rich areas often found in non-gateway markets where strong average annualized young adult population growth is evident.

As the millennial workforce shifts to the more cost efficient non-gateway markets, employers, chasing top talent, are following suit. Non-gateway markets offer lower rental rates, larger parking ratios and often better access to labor pools outside of the high cost gateway cities. Rent growth in non-gateway markets is expected to be more than 25% higher than in gateway markets in 2018. By 2020, it is estimated nearly half of all workers in the U.S. will be millennials, the majority of whom are finding non-gateway markets to be attractive places to settle.

With this shift, commercial office landlords investing in amenities and connectivity for their tenants are poised to capture this demand — especially as employers look for office space that will help them recruit and retain the millennial workforce. To attract the tenants, landlords are upgrading assets with amenities that are appealing in urban environments such as cafes, fitness centers, co-working space, and collaborative lounges with indoor and outdoor entertainment areas.

For tenants, these types of live-work-play environments appeal to millennials as they move from expensive city life to more affordable markets offering attractive employment opportunities, without having to sacrifice the retail, social and entertainment amenities they desire. In addition, many of these markets are facing increased traffic congestion, so businesses and their employees remain faithful within the market to minimize commute times. This serves to intensify the internal growth of these markets with retail, housing, entertainment and commercial property demand.

As landlords reposition assets to create value, investors may generate a higher yield as a result of the millennial shift to non-gateway cities. For companies, lower rent rates and a strong talent pool present an obvious opportunity. In fact, non-gateway markets outperformed gateway markets in rent growth last year (3.4% vs. 1.2%, respectively) and according to Cushman & Wakefield, sales of office buildings within central business districts dropped 23% in 2017 from the previous year.

With gateway market rent rates at new heights, non-gateway cities provide growth opportunities that gateway cities are unable to support. At the end of 2017, non-gateway secondary markets averaged a cap rate of 6.1% compared to 4.8% in gateway markets, providing investors with the opportunity to secure assets in up-and-coming areas.

Based on the data, non-gateway real estate investments offer an attractive investment opportunity with growing activity and optimism compared to gateway cities. That said, non-gateway cities, and their submarkets in particular, are not homogeneous in nature and should not be treated as such. Investors with active operating companies and strong knowledge of local markets are focusing on geographical centers of business, where the economic development and growth is highly centralized. More specifically, prime suburban markets with walkable amenities and easy access to public transportation, newly developing prime business centers that were once considered suburban cities and new urban growth are all creating opportunities for commercial office real estate investment.

Jeff Shaw is a senior partner at Bridge Investment Group and CEO and managing broker of Bridge Commercial Real Estate in Atlanta. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.