How to Find the Best Cities to Invest in Commercial Real Estate
The benefits of investing in real estate are well documented, from portfolio diversification and tax efficiency to accumulating tangible assets that not only generate cash flow but also appreciate over time. Properties that generate income, namely commercial and multifamily assets, are the cornerstones of any real estate investment strategy. But determining where to buy matters most; not all markets are equal.
So, where are the best places to invest in commercial real estate?
Commercial and multifamily real estate markets are always evolving, so at Origin, we evaluate the best places to invest in real estate on an ongoing basis. Yet as our acquisition team acquires an intimate knowledge of a market and its underlying fundamentals, we need to guard against acting on hunches that aren’t borne out by the facts. In the same way that the discounted cash flow model has proven accurate and reliable in underwriting investment opportunities, a number of powerful economic indicators reveal whether properties are likely to generate high risk-adjusted returns.
Weighting Fundamentals is Crucial for Analysis
Every city, and its surrounding metropolitan statistical area (MSA), has its own economic drivers and growth indicators. These fundamentals are tracked and documented by many sources, from U.S. government agencies such as the Census Bureau and Bureau of Labor Statistics, to real estate-focused think tanks such as the Urban Land Institute and market research firms that sell data subscriptions. Our proprietary predictive model starts with data from many of these respected industry sources.
But data alone isn’t enough. The key to our model, or secret sauce if you will, is the way we weight the fundamentals. Just as we objectively evaluate risk factors in a potential investment, weighing commercial real estate fundamentals in a formula to determine where to invest removes bias from our analysis. The result has been a model that’s methodical and rigorous—and gives us an unbiased foundation on which to base our market selection strategy.
Developing Our Objective Model
Our entire senior acquisitions team and investment committee has been involved in compiling, reviewing and weighing the underlying data we use for our model. For our initial ranking, once we determined the weightings, we scored our eight existing investment markets and all the potential expansion markets we have been considering and compare them against each other. We found that we had done a great job in our initial market selection, as our existing target markets all scored in the top 10-15 markets out of the 26 markets we evaluated. But the exercise was very worthwhile, as we now have a systematic process that frames our internal discussions as we decide where to invest. The model will require us to update the weightings at least annually since market fundamentals are always shifting. While our model uses closely held real estate economic data, various public sources also reveal some important aspects of where to invest in property.
Our 9 Most Important Fundamentals
We believe there are nine proven indicators of a potential investment market’s success, and the data on each of these fundamentals power our weighted model. Here is the list of the primary drivers of the model, and where to find them:
1. Population Growth. The U.S. Census Bureau estimates population changes from year to year. A city’s population growth drives demand for real estate. For commercial and multifamily properties, a rising proportion of millennials (ages 18 to 34) is a strong indicator of future demand. A recent Brookings Institution study found the greatest 5-year millennial gain in Colorado Springs, Colorado.
2. Job Growth. The U.S. Bureau of Labor Statistics finds the year-to-year biggest workforce gains in Orlando, Florida, Seattle, Washington, and Houston, Texas. Orlando also scores highest in our 5-year projection of growth momentum.
3. Business Costs. Ease of starting a business is measured by many popular rankings, including the Inc. 5000 fast-growing companies list. The World Bank’s global Doing Business index is widely imitated for sweeping up factors like taxes, energy and credit—costs that also get considerable weight in our real estate algorithm. In its fast-growing cities list, Forbes incorporates a pay component, led by Seattle’s 7.52% wage growth in 2017. (Forbes’ population growth leader was Boise, Idaho.)
4. Industry Concentration. Investors weighing the prospects for medical offices might consider a city’s health-care employment pool. An annual survey by the Urban Land Institute and the PwC consulting firm notes the high proportion of education and health jobs in Brooklyn, New York. For science, technology, engineering and math jobs, Boston and Philadelphia score highest. But less expensive markets like Orlando also score well above average in these sectors.
5. Housing Affordability. A high hurdle to investing in gateway cities like New York, Los Angeles and San Francisco is their high cost of housing. Realtors and other trade groups compare home prices to local median income. In the National Association of Home Builders/Wells Fargo rankings, San Francisco frequently scores as least affordable housing: A $119,000 income was enough to qualify for a loan on only 5.5% of the homes sold there. As much as anything, Chicago’s affordability relative to other global cities is what attracts real estate investors.
6. Investor and Civic Sentiment. The ULI survey is known for measuring investor and developer interest—Dallas/Fort Worth, Brooklyn, Orlando, Raleigh/Durham and Nashville are 2019’s leaders. But we also consider lifestyle, transportation and other infrastructure indicators. The consulting firm Resonance gives Chicago a perfect score on a “product” index that includes airport connections, higher education, museums and sports. Chicago also leads the Site Selection magazine corporate relocation ranking. Civic assets also figure in the top-10 lists of personal investment site SmartAsset: The top work-life balance score for Madison, Wisconsin, is based in part on its high proportion of arts, entertainment and recreation facilities.
7. Capitalization Rates. To find commercial properties, investors can get fixated on cap rates—the amount of net income generated in the first year of ownership (not including capital expenditures or debt service) divided by the purchase price. But it’s important to know that year-to-year price movement can be volatile, as measured by subscription services like Real Capital Analytics. In our markets we track not only cap rates but their local track record for volatility—call it a VIX for real estate—to get a better fix on how much risk exists in owning assets there over a long period.
8. Rent Growth. Market-wide, multi-family properties in Indianapolis are now averaging a 6.0% cap rate. In Los Angeles, it’s 4.5%. That makes LA an expensive place for investment relative to Indy—unless annual rent increases in LA rise substantially over time, which has been true historically. Over the next five years, Indianapolis rents are projected to grow at 2.25% per year and LA’s are projected to grow at more than 3.0%. If rents don’t rise in LA at the projected pace, it would have been better to buy in Indy. That’s why we are focusing on markets such as Phoenix and our other target investment markets for now, which all are enjoying moderate cap rates (5.25% in the case of Phoenix) and high projected growth (over 3.25% per year). Currently, they appear to offer better prospects for real estate investment.
9. Supply and Liquidity. Two other important metrics that are evaluated and factored into our model are the amount of new supply that’s being developed in a particular market (tracked through a variety of data sources and municipal permitting departments) and how liquid the market is (the number of transactions per year relative to the total inventory). The supply side of the equation is evaluated against the demand side, which is often assessed in terms of job and population growth, to determine the impacts that this new supply will have on the existing stock and the ability to achieve the forecast rent growth. Liquidity, defined as the amount of buying and selling in a particular year, is an important metric to track for two reasons: it provides an investor with confidence that there is an ability to gain scale in a market through future acquisitions thanks to healthy transaction activity, and a liquid market generally offers more options when looking to sell an asset.
Using the Model
The success of a commercial or multifamily real estate deal is heavily dependent on local fundamentals, and opportunities for steady income and price appreciation aren’t found everywhere. Our model is used to test the strength of every deal we consider, as well as to guide our efforts to grow and scale in new markets.
The best real estate asset managers draw from a deep understanding of how markets work and property investment strategies that spot emerging trends. Our model helps us make sure our analysis is objective and will yield results that benefit our investors.