While that may be a bit of an overstatement, the apparent resurgence of America's downtowns earned an article in the Wall Street Journal last December. It is an interesting idea, and broad structural changes like the one described in the article do tend to grab headlines, but looking at occupancy trends for commercial real estate—and office in particular— the data have yet to tell this story convincingly.
On the surface, a number of arguments seem to support the thesis of a rebound for downtown markets; some are more compelling than others. One, for example, is that businesses prefer downtowns because they are closer to clients and suppliers, which makes it more efficient to operate downtown than in a suburb. Another is the take on rising energy costs, which posits that individuals prefer downtowns because it lowers commuting costs by employing a mix of transportation options that are not as readily available in the suburbs. Moreover, declines in the incidence of crime in major cities over the last 20 years have made downtowns safer and more desirable, not just for commuters but also for residents. And finally, downtowns are just cooler than the suburbs. After all, you just can't find that cool, hipster coffeehouse vibe in the suburbs; you really need to be downtown for something like that.
Personally, I don't buy a number of these arguments. Let's begin with lowering commuting costs. In order to lower commuter costs we need to start with the assumption that most markets have a well-developed public transit system. They don't. Outside of Boston, Chicago, New York, San Francisco and Washington, D.C. there are simply no well-developed public transit systems to measurably reduce commuting by car—and thereby the expenses of commuting into a downtown area for work.
Crime is the one area where I agree; over the past two decades, cities have become safer. No argument there. Still, inner-city schools remain underfunded, understaffed and on the margin dangerous enough that most families with the means either move to the suburbs or opt for pricey private schools. So with families prone to relocating to beyond the city limits, what are we left with? That's right: the 20- and 30-somethings that make those coffeehouses so darn hip. And guess what? In those very coffeehouses, many of them are coupling, settling down, and unwittingly—and metaphorically—packing their bags for the greener pastures of the suburbs.
I don't mean to be a downer, but that's life. So let's get to the core of this argument, which is why businesses and investors flock to downtown locations. It's a more compelling argument, but even so it's not necessarily a slam-dunk for downtown office assets, nor is it the death knell of suburban office as we know it.
The notion of downtowns is great for business; being there offers both prestige and efficiency, in many cases. Tenants who take up space in downtown submarkets often do so to be closer to partners, clients and important business services. They offer a central location so businesses can draw commuters from the city and close suburban locations—perhaps even further out if they are in one of the aforementioned transportation markets. But, as economists like to say, there is no free lunch.
On average, the price per square foot of office space downtown is about $10 more than that for the suburbs, according to our TW rent index; and before you ask, this does account for asset-quality differences between posh high-rise business-district towers and smaller business-park offices. That margin may not seem like much, but consider that the difference is applied to an average five-year lease on 10,000 square feet of space. That's a difference of about half a million dollars, not accounting for the future value or opportunity cost of a five-year period.
Surely, as is the case with individuals, each tenant has its own utility function and budget constraint that determines both its willingness and ability to pay for office space. That said, to assume that downtown locations can command increasingly higher rents based on efficiencies and a general desire to be near a city center is to ignore the price elasticity of demand for space. At some point, the relative price of downtown space becomes too high to attract tenants away from their suburban locations. Moreover, it also prices certain businesses out of the market. For example, most investment banks in New York don't consider rents at all; they simply build new headquarters or purchase existing space outright. Large corporations also may have more flexibility on pricing, but this is not the case with smaller companies with less extensive operating budgets.
Another interesting way to view the relationship between downtown and suburban office markets through the eyes of a potential investor is by looking at movements in rent. The cyclical relationship is such that during the downside of a rent cycle, rents converge as they fall faster and further in downtowns than they do in the suburbs. As an example, in the most recent recession, effective rents in downtowns fell by nearly 22%, while in the suburbs they fell by nearly 13%. A similar pattern is evident through each of the past three recessions. It is also true that on the upside there is more rent growth in downtown markets, particularly near cyclical peaks where downtown markets tend experience rent spikes, while rent increases in the suburbs tend to be slower and steadier.
On the whole, however, average rent growth tends to be nearly identical between downtowns and suburbs, particularly when one accounts for the additional volatility inherent in downtown markets. Though this seems to run counter to current conventional wisdom, much of the evidence suggests that the desire for businesses and individuals to pursue inner-city locations may be a little overstated. In fact, current data on office fundamentals suggest that the suburban office market may be leading the broader office recovery. Vacancy rates in the suburbs, for example, began to stabilize in early 2010, while downtown vacancy continued to rise through the third quarter of the year. And thus far, suburban markets have provided a majority of the demand increases we have seen nationally over the last year.
Still, if you talk to office investors, no matter what sort of data you present them, there is a perception that downtowns are the way to go—but for different reasons than mentioned above. They'll seldom argue about rent growth and volatility when it comes to suburbs versus downtowns, but it comes down to the more subtle differences in lease structure and capital expenses associated with leasing in these two types of markets. Suburban leases tend to average about four years where leases done in downtowns can run from five-to-10, sometimes more in certain, sought-after CBDs and financial districts. Because leases in the suburbs run shorter than in downtowns, investors need to consider that they will be laying out additional capital expenses to prepare and market space more often. The cyclical volatility issue notwithstanding, this means additional expense and risk.
Moreover, many investors are under the impression that office investments in CBDs are somehow safer and more insulated from risk than suburban investments. The evidence to support this is pretty clear. Over the past year, cap-rate compression has been far greater in CBDs as investors have tried to chase core and core-plus assets in select markets, in what is amounting to a flight to quality. And while investor preference is well-defined, the fundamentals—at least at the market level—don't necessarily support these improvements. Rather, it is the perception that larger more well-developed downtowns provide more security in the way of liquidity. That is, the ability to convert an asset into cash quickly. Yet, even despite recent trends, there is not a great deal of evidence to suggest this is the case; as the volume of transactions has remained evenly balanced across downtowns and suburbs. It simply boils down to what investors are willing to accept in the way of risk premium for each location.
So the question remains: where is the future of the office market? The demise of the suburban office market is likely overstated. With population centers more dispersed now that ever; there remains a need for office space outside of city centers. Suburban office centers will continue to allow businesses a lower-cost alternative to downtown space and will allow employers to locate conveniently near their workers. Suburban space will also continue to serve investors that are looking for a way to diversify their portfolios and are willing to research and seek out quality income-earning properties that will provide a stable revenue stream.
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