Post-Pandemic Demand Boomerangs Back to Cities

Dave:

What is the fate of US cities and their surrounding metro areas? After the pandemic and the rise of remote work, are we going to see the continuation of recent trends where people are moving to the suburbs or will we see revitalization and can we expect more renters to move in rent growth? Today we’re going to dig into what’s going on in America’s City’s post pandemic.

Dave:

Hey everyone, it’s Dave and welcome back to On the Market Podcast. Today we’re talking to a fan favorite guest friend of the pod, Richard Barkham. He is the Global Chief economist at CBRE. If you don’t know them, they’re a huge commercial real estate firm and we’re bringing on Richard today to discuss the revitalization of cities post pandemic. He and his team have done a lot of original research about recent trends, and lemme just give you a little bit of a background, but for most of the last 20, 30 years, most of the growth in real estate has come in cities. But then that sort of reversed during the pandemic and suburbs and even rural areas started to grow faster and Richard’s team wanted to figure out is that going to continue or is it going to change? So that’s what we’re bringing on Richard for. We’re also going to talk about the macroeconomic environment, inflation rates, cuts general news, so that’s the plan. We’re getting into everything today. Let’s bring on Richard. Richard, welcome back to On the Market. Thanks for joining us again.

Richard:

Oh, I’m delighted to be here.

Dave:

I am eager to talk to you about some work that your team put out about what has happened to us cities in metro since basically the beginning of the pandemic and now in sort of the years that have followed. So I’d love to just ask you to lay some groundwork for us here and tell us how cities and specifically their economies have changed since the beginning of the pandemic.

Richard:

When the pandemic first hit and people had to isolate, it was accompanied with massively increased adoption of technologies that allowed remote working. It was probably a pent up movement, but we had a trend towards people living and working in the suburbs. So a movement to the suburbs and more time spent in the suburbs at the detriment perhaps of the downtown areas. We’ve had incessantly replayed to us in the media a kind of boom loop narrative. It’s not as exaggerated as the media have laid out, but there has been more or less a permanent shift of spending, if you like in the downtown areas. Move to the suburbs, I wouldn’t overstate it. The point that our report paints out is that American cities relative to global cities, the suburbs have always been rather dynamic. Suburban. Living with big houses is one of the preferences of American society.

Dave:

Thank you for laying that groundwork, Richard. And I’m curious if this has happened universally across the US because a lot has been made about San Francisco or New York City and sort of a lot of the exodus and declining population from those cities. But is this happening in other parts of the country, like the Southeast? We hear so much about people moving to the southeast. Are they moving to the suburbs or are they moving to cities?

Richard:

Yeah, I mean I think there are differences between city types and our report lays out four basic city types. We’ve got the super cities, which are New York and Los Angeles. We’ve got major cities, we call them mixed majors, which might include Boston, Chicago, Philadelphia, San Francisco. Then we’ve got what we call sprawling darlings, which are the kind of the Sunbelt cities with huge growth in population from internal migration and that’s flooding into the suburban areas. And then we’ve got developing destinations, places like Austin, Charlotte, and Miami. And the dynamics of each of those city types is a little bit different. And I think that the case of the sprawling darlings, which would include where I’m currently located Dallas, but also Austin, then I think there is still a tremendous suburban development as population moves in. I mean there is downtown live work, play type neighborhoods, but the dominant trend there is suburbanization. But in the case of New York and Los Angeles, which you pointed to during the pandemic, we originally did see that population was moving at, I mean our sense now is that population is moving back in. And certainly in the case of New York, just an incredible demand I think for downtown living. Even if people are not fully returned to the office, the amenities of those super cities are just incredibly powerful magnets for people. And so the multifamily sector, both in Los Angeles, New York running very hot at the moment,

Dave:

I think that sort of jives with all the other data and trends that we’ve been seeing around migration and patterns here. We do have to take a quick break, but stick with us. We have more with Richard Barkum when we return. Welcome back to On the Market podcast. We’re here with Richard Barkum from CBRE. You mentioned earlier this concept of a doom loop and you also said that it’s not necessarily coming true, but could you just tell us a little bit for those who haven’t heard this term or have seen a headline and don’t fully understand, what is the concept of a doom loop that everyone seems to be going on about?

Richard:

Well, I mean everybody’s got their own kind of doom loop, but I think what it means is that people are not working in offices, therefore office vacancy is elevated, therefore office values are formed and the revenue therefore that the city governments get from the office sector, the property-based tax revenue has gone down. And that prevents infrastructure and service provision in downtown areas and therefore more people want to move out and less people want to work there. In fact, if you actually look at state and local government revenues, they’ve been sky high over the last two years. And if you look at where jobs are being created in the US economy, it’s still in state and the local government is a major job generator. So some of that elements of that doom loop just don’t apply. And of course, as I previously said, for all that, we still have high vacancy in the office sector. There are elements of the office market that are really thriving and particularly in the developing destinations and the super cities, people are flocking back into those cities. They are still places that people want to certainly live and also work, if not always 100% in offices.

Dave:

And a lot of the media coverage is about office buildings and office towers in particular. And from what I’ve read, and correct me if I’m wrong, Richard, a lot of it is those sort of more typical type offices, corporate buildings, but as you said, there are other types of office and commercial assets even within cities that are doing well. So can you tell us about some commercial asset classes that have proven resilient in cities?

Richard:

Yeah, I mean just let’s start with the office sector, Abby. It’s quite interesting. Our latest research, which is just being published and is available on the CBRE website, we look at what we call prime offices. So those are the best quality offices usually the most recently built offices maybe since 2010. And those types of offices far from leaking tenants are actually gaining tenants, what we call net absorption is actually really positive in those prime offices and that the rents are holding up, the rents are growing. It’s not just a question of the construction of those buildings, but those are the buildings that exist in vibrant live work play type environments. So I would say prime offices even in cities are actually thriving.

Dave:

When you say that they’re growing in terms of occupancy and rents, is that because they were extremely low? How does that compare to occupancy levels and rents pre pandemic? Well,

Richard:

I mean I think the vacancy rates would be higher. The vacancy rates of all offices are higher than pre pandemic, but the vacancy rates, generally speaking, I think in the office sector would be around 20%. So 20% of the stock overall is vacant within prime offices. I think the vacancy is 12 to 14% and it is heading down quite quickly because you’ve got positive net absorption. In other words, more people taking more space than they’re giving up in that prime office segment, which admittedly is only eight to 10% of the overall office sector, but it is nevertheless very vibrant. And the thing to remember I think from a perspective of investment is that the rate of completions of new offices has dropped considerably. So I can’t remember the exact statistics, but it will be about 40 million square feet of offices completed this year and maybe 15 million square feet of offices completed in 2025.

Richard:

And therefore, I think by the end of 2025, we’re going to have this rather surprising situation where you have overall vacancy, but we are going to be short of prime office space. The best quality space will be moving into a period of very low vacancy and companies that prefer that space won’t be able to get it. And I think investors will want to look at that sector giving potentially good returns because the competition from new development is going to be very restricted I think for the next three or four years, particularly in the super cities, but not limited to the super cities.

Dave:

Now. See, I like this. This is very contrarian view and I appreciate that that office has some potential.

Richard:

You get the best bargains in the most bombed out markets. But

Dave:

Yeah, it it’s bottomed out for sure. I mean it’s really gotten hit hard, but I think what’s interesting here is what you’re describing with the office market is actually quite similar to what we see almost in the residential housing market. Whereas if you look at overall supply in the office space is it seems like plenty of supply, but the demand is for a very particular type of office and there’s not an excess of supply there. Do you see that in the housing market where we talk about people want single family homes, are there other types of units available? Yes, but people want single family homes and there aren’t available single family homes. So it makes me wonder if investors if there’s an opportunity to retrofit or upgrade older office buildings into a class office space because as you’re forecasting demand for that particular subsection of office.

Richard:

Yeah, I mean I think funnily enough, when I was reflecting on doing this podcast this morning and thinking about the work that we’ve done just to position and the evolution of cities, what would be the investment strategies? And that was absolutely number one that popped into my mind as we move forward over the next 12 to 24 months and interest rates start coming down, then I think moving retrofitting offices to bring them up to a higher level of spec in the right live work play neighborhoods is absolutely a number one strategy. And I have to say, I may not look it, but I’ve been around looking at property cycles for the last 40 years, since the 1980s, and I remember actually teaching this when I was a professor that the stage one of the office cycle always is a refurbishment strategy. That’s typically how, and I think that’s what’s going to happen over the next 12 months. We’re going to see the start of the next office cycle. People might find that strange, but there will be an cycle and the best strategies will be around refurbishment.

Dave:

That is really, really interesting. It’s getting me a little bit excited about it because so much people keep talking about retrofitting offices into residential and although that sounds amazing on paper because we need a lot more residential, a lot has been made. And please expand on that if you could. How difficult it is to retrofit office, a lot of types of office into residential for a host of reasons, but refurbishing B class office to a class office now that seems feasible. So I wonder if you think that’s going to decrease even further the interest in trying to do these office to residential conversions?

Richard:

Well, I mean the technical challenges with office to residential construction are quite large just in terms of putting services in that support residential activity into some of these kind of glass and steel buildings that date from the seventies and eighties. It can be done. There’s basically nothing you can’t do with a building, but it’s very expensive at the moment for that area of activity to gain pace. We’re seeing quite a lot of it, but that’s going to evolve at maybe one or 2% of the stock per annum. I think that would have to be supported by subsidy and grants, and we may well yet see that coming in if cities want to accelerate and investors really ought to keep an eye on what cities are doing to accelerate this conversion process. But I think the point that you asked about should we be converted offices into better offices, absolutely we should. And that’s a much less costly strategy I think. And it’s also one that is kind of a sure file winner if I’m reading the cycle correctly, that we’re going to be short of prime grade space and I think we’re going to be short of prime grade space, particularly in Manhattan.

Dave:

I think it’s wild what you’re saying here, given all the headlines about office space, particularly in cities like New York. But I guess in some sense it makes sense to me that prime is going to be the most important because if you are going to require people to come into the office, they probably want to make it an appealing proposition to people to get them to accept a job where they come in. In New York, if you’re in finance, you probably want people in the office every day and you need to make it a positive experience so that people don’t go looking for remote work. Is that sort of the idea?

Richard:

Yeah, I mean, if you don’t mind if I just put my professorial hat on again and talk about this in urban economics, the big trend in cities over the last 50 years, I mean cities are expensive places to live and to work, and therefore lower skilled jobs that don’t necessarily justify a high cost location tend to be relocated. And some of those jobs, they’ve been relocated to the suburbs. Maybe some of them have been relocated to some of the emerging markets like India and the Philippines. But I think part of the remote working is just that some jobs can be done in the suburbs and what does that mean in a longer term perspective? If those lower skilled jobs exit the downtown areas, it creates conditions that look bad at the time depressed kind of rents, but that allows new businesses to be created. And those businesses over the last 30 or 40 or 50 years have been generally high skilled businesses, even more high skilled. So I see the evolution of cities, it’s going to be more highly skilled workers, the need to be located downtown. And of course the need for face-to-face contact and client interaction and the kind of creative processes is greater in those types of jobs. So creating an environment where very highly skilled people with a lot of human capital can interact and create the products and services, that’s what the office platform has to support and create and foster.

Dave:

And Richard, how would this thesis that you have play out in the residential space, because when I hear you speaking about this, I think wow, maybe investing in residential around those areas could be good. If they have to go to the office, they’re probably going to want to live close to it. And it sounds like these are probably going to be high income types of positions and we might see sort of a reversal of recent trends and getting back to more long-term trends where rents grow faster in the city than in the suburbs, which of course changed during the pandemic.

Richard:

Yes. I mean I think that’s actually been a story just in this last week or two. The Wall Street Journal picked up on this fact that net absorption in multifamily, it’s actually been quite good. We’ve got a wave of supply and multifamily, but absorption has been quite strong and places actually like the Midwest, but also the Northeast rent growth is beginning to pick up again. And they’ve put two and two together and made six or seven and said, well, if we’ve got rent growth, that’s going to feed into inflation and maybe we won’t get interest rates falling. I think that’s wide of the mark. But the point that they’ve picked up on is just, and we’ve got a report out now it’s available, it’s on the CBRE website, but these multifamily in what we call the inner ring, not maybe downtown but close to the live work play neighborhoods, the vibrant neighborhoods, rents are growing there at about 3%.

Richard:

It doesn’t sound a lot, but given that we’re just emerging from a flat rental period of multifamily, those are the assets, the assets people still want to live in downtown areas. And remember as well, the US population is growing, internal migration is heading to the Sunbelt states, but if we have international migration, which is quite often the highest skilled people coming into work in corporate America, they tend to locate in the coastal cities. And plus you’ve got a new wave of folks coming out of university wanting to live downtown. So those that multifamily assets in vibrant neighborhoods in the big cities doing very well at the moment.

Dave:

I like to hear that. I mean, just on a personal basis, my whole investing thesis for most of my investing career has been to try and be close to downtowns wherever I’m going. But then recently I bought my first units in the suburbs recently because things have just changed and rent has been growing so much. But I don’t know, something about the downtown thing just makes sense to me. So I would love to be able to focus on in major metro areas. Again, I get it more, I don’t know.

Richard:

I don’t want to be a person that says all well in every situation, but with unemployment at 4%, with the US population growing, the economy growing, you can sort of run both strategies at the moment. I think a suburban strategy, particularly in the Sunbelt cities, particularly with vibrant live workplace suburbs, there are parts of the suburbs that are more highly dense and that’s a viable investment strategy. But I also think the downtown areas are viable investment strategy. And if you’ve really got a long-term perspective, and not everybody can pull this off, I think the biggest gains are going to go into to invest in those downtown areas, which are not fully vibrant at the moment, but might be just in the process of flipping. They’re very expensive places to live, downtown areas, and people are looking for cheaper rents that can often be the catalyst to create in a whole new district or area. And it can come up. And I think that’s where you make the biggest gains in real estate is going to the areas that are not popular, but are just on the cusp of flipping into really vibrant locations. And quite often actually what you actually see is that it’s the kind of artists that go there first and there’ll be Richard Florida has talked about the kind of boho type of index, but it’s the artists that kind of go into these areas and revive them.

Dave:

Just from personal experience, I’ve always found it a little bit easier to identify markets that might be on the up and up in downtown areas just because more compact and there’s fewer of them. And when I drive around, even in a city I know very well, like Denver, there’s so many different suburbs, I find it very difficult to understand which one is going to become really popular and which one is going to see good appreciation or rent growth. Whereas in a city, maybe it’s just me, but I just am able to identify that more. So I totally get that. We got to take one last quick break, but more from on the market when we return. Welcome back to the show. Let’s jump back in. Richard, you talked, I can’t resist the temptation to ask you about macroeconomics because you talked about the economy growing. You talked about population growing. We’re in a weird spot right now. The economy is growing, but the growth rate is slowing down. We’ve gotten mixed signals from the Fed. What do you see happening over the second half of 2024?

Richard:

You’re right. I think the economy is slowing. I think you can see it in increasing number of indicators, and I think the Fed will be worried about that. We can see inflation is heading down, and I think most people’s projection is that it will be down to around two, 2.5% by the end of 2025. But we’ve still got some areas, some pockets of concern around the inflation front. But I think on balance, we should expect maybe one or two interest rate cuts in 2024 and maybe three to four in 2025. So I think the Fed will begin to ease slightly. And one of the things I’m concerned of, if you want to look at the economics of all of this, is even though the federal funds rate has been steady now for 12 months or so, actually longer than that, because inflation has made some gains, what we call the real interest rate is continuing to increase. And I think there are signs that it is biting

Dave:

Inflation gains. You mean actually going down like improvements?

Richard:

That’s what I meant, yes. Yeah, no,

Dave:

I just want to clarify for everyone that it’s not going up.

Richard:

Yeah, that’s right. But it’s making the real interest rate go up and economists like real variables, which is the variable minus inflation. So I think the Fed will be concerned about that. I mean, the labor market is still strong, but we expect that to weaken over the course of the rest of the year. So I think cuts, we won’t get a July cut, but we may well get a September cut.

Dave:

And can you just help explain to our audience why real interest rates are important to the economy and to the Fed in particular?

Richard:

Yes. I mean, I think if you look at the statistical evidence, it’s always the real interest rate that does the work. I mean, if you are facing a 5% interest rate, but your revenues are going up at 3% just because of inflation, the only thing that you really need to worry about is that kind of 2% real interest rate. It’s one of those variables that people don’t understand, particularly in their daily lives. But if you look at the statistical evidence, it has quite a bearing on investment and consumer spending and actually real estate values as well, actually strongly linked to the real interest rate. The other thing to remember, just on the issue of the real interest rate, we’ve had a period probably going back to the financial crisis, 2008, 2009, where what we’ve had is negative real interest rates. So we’ve not only not had a real positive real interest rate, we’ve had a negative one, and that’s been very supportive of real estate values and economic activity. Now we’ve moved to a position of positive with interest rates. That’s a bit of a shock, and it takes a while for that to feed through into the economy, but it is now feeding through.

Dave:

Well, thank you, Richard. This is very helpful and something that I think our audience could keep an eye on. It’s not just looking at the federal funds rate, but the relationship between interest rates and inflation is really, really important as Richard just showed us. Richard, before we get out of here, any last insights or information from your research that you think our audience should know as it pertains to the future of cities and real estate values in those cities?

Richard:

I mean, I think we do still, despite what I’ve just said about real interest rates, our view is, and I think it’s the dominant view, that we’re still going to get a soft landing in the economy. There are a number of reasons for that despite the fact that there is some evidence of stress showing up in the consumer sector, consumers are generally speaking in a good shape. They’ve got low levels of leverage and they’ve locked into low, low interest rate mortgages. So consumers somewhat resilient. And also I think some of the government stimulus that people may have forgotten about. We’ve heard about the chips and the IRA ACT boosting investment in manufacturing structures, but you should remember the Infrastructure Act, which was bipartisan. There is a lot of construction coming on infrastructure over the next three or four years, and I think that all points to a soft landing.

Richard:

So a soft landing with interest rates coming down, they’re not going back to the levels that we had 2009 to 2019, but they are coming down will allow some value recovery over the next two to three years in real estate. But I think the economy is in a good place, but it is changing and cities are evolving. Investors have to really look at real estate, not just as a surefire capital growth story. They’ve got to be thinking about buying real estate and positioning it for a changed market environment. So active management is really the key to unlocking real estate gain. I think over the next two or three years, really being entrepreneurial with the real estate that you buy, not being afraid to invest in it and repositioning it for a new and changed world.

Dave:

Beautiful. What a great way to sum it up. Thank you, Richard. And if anyone wants to learn more about Richard, the report that he and his team have put out on the future of cities is amazing, super interesting, great work that we will link to. We’ll also put all the other contact information in the show notes below. Richard, thank you for joining us and to all of our listeners, thank you so much for joining us today. We’ll see you very soon for another episode of On The Market.

Richard:

Pleasure. Thank you for having me

Dave:

On. The market was created by me, Dave Meyer and Kaylin Bennett. The show is produced by Kaylin Bennett, with editing by Exodus Media. Copywriting is by Calico content, and we want to extend a big thank you to everyone at BiggerPockets for making this show possible.