In every aspect of our economy, advancing technology and evolving demographics are fueling significant changes in demand patterns. How we live and work is increasingly “amenitized” and connected, which influences consumer and business decisions. By its very nature, our physical infrastructure lags changes in underlying demand, and today there is a need for much of our existing real estate to be transformed to meet the demands of the new economy. This need is providing attractive return opportunities for investors through value-add real estate investment in select markets.
Examples of these opportunities are prevalent across real estate sectors. Office space is increasingly used as a tool for companies in the new economy to attract the best talent, and these companies are seeking open, aesthetically pleasing, amenity-heavy space that maximizes convenience, community culture and efficiency. The composition of housing has shifted in the new economy with a decrease in ownership and corresponding increase in renters. As a result, apartment product needs to appeal to a deeper and broader tenant pool that is renting longer and transitioning through life phases. In retail, consumers prefer experiential or necessity-based shopping over traditional, commodity retail that can be supplanted with the convenience and price transparency of e-commerce. To support this, obsolete retail real estate needs to be transformed and industrial infrastructure adapted to efficiently manage inventory, transport and delivery of e-commerce goods.
To date, changes in underlying demand trends have been most readily met via new real estate supply in gateway markets. However, the cycle is seeing a broadening of the universe of investable markets to include non-gateway cities that enjoy the same underlying demand drivers, but where the supply response has lagged. In addition, many of these cities offer less competition and more attractive pricing to investors. In the midst of this evolution, attractive opportunities exist for new and transformed real estate outside of gateway markets to accommodate changing demand patterns, opening the door to new markets to further participate in the new economy.
Value-add real estate investors need to understand not only how the new economy has evolved, but also correctly anticipate where it is going. Comprehending employment drivers and growth trajectories in individual submarkets, as well as how best to fill demands related to these economic shifts, will be vital to the success of a real estate portfolio. The ability to identify an asset that will respond to submarket voids, and re-imagine functionally obsolete real estate into high utility assets positioned logically and accretively will set apart a successful value-add real estate strategy over the next decade.
THE OPPORTUNITY
Different regions and submarkets in the United States reflect varied components of the new economy. Not every real estate market is responding the same way to national secular trends, due to the evolution of its individual workforce, industry footprint and the vitality of its existing urban core. For example, creative office space in downtown Denver may be highly desired for technology-centered tenants, while large-floor-plate, high-density back office space for a corporate call center is in demand in suburban Dallas. An urban retail asset with high-end restaurants and other experiential tenancy succeeds in downtown Chicago, while neighborhood centers with necessity-based service tenants, such as grocers and fitness centers, are the right focus in the family-friendly suburbs. A large, modern distribution warehouse is not likely to be found in the heart of a major urban core, but smaller, older, light industrial infill assets can find new purpose with improving small business demand and a growing need for last-mile delivery.
There is a sweet spot for attractively priced, in-demand commercial real estate in the middle market segment of major non-gateway markets; those areas often overlooked by institutions in favor of larger deals in gateway cities. These submarkets often enjoy many of the demand drivers of gateway markets but with less supply and higher implied yields (capitalization rates), while the middle-
market transaction size hones in on assets with less competition and more inefficiencies in the market. Within these markets, however, we encourage investors to be extremely selective. Assets must contain the appropriate physical features in the right location, predicated by a full understanding of the potential benefit to a group of identified end users.
OFFICE
The changing nature of office space in the new economy has primarily been represented by the demand for urban and modern space. Previously reserved for technology or creative companies, office space with an open, aesthetically pleasing interior in an amenity-rich environment is now in demand across many industries and in many major markets as companies compete for the best talent. However, the evolving landscape of office demand manifests itself in different ways, and not every city or submarket has the appropriate infrastructure or attributes to appeal to the millennial-driven creative urban mindset. For example, certain low-cost, business-friendly suburban markets are driven by demand for back-office and customer support functions, for which large, efficient floor plates and high parking ratios are more important competitive advantages.
INDUSTRIAL
The changing nature of industrial space in the new economy has primarily been driven by the demand generated from e-commerce. The new and growing e-commerce supply chain has accelerated demand for industrial warehouse space — both large distribution centers and smaller, last-mile facilities — to satisfy the expectations of immediate delivery of goods. New development has been focused on larger, higher-clear-height, more-efficient distribution assets to meet this growing demand. Concentrated in a handful of large distribution-
oriented markets, this real estate has been in high demand from institutional investors. However, other investors have sought to capitalize on opportunities in the industrial distribution space by identifying existing, functionally challenged properties near major population nodes, with access to transportation infrastructure and supported by a deep employment base, to transform into assets with the necessary competitive attributes to compete in the new economy. Additionally, a resurgent small business segment in need of infill, logistically accommodative urban industrial space has buoyed demand for smaller, lower-clear-height, light industrial assets. As the composition of potential tenants for this product evolves, the opportunity exists to reposition these light industrial assets to capture the growth from e-commerce delivery needs.
RETAIL
Of all the core real estate sectors, the shifting trends of the new economy have had perhaps the most significant impact on retail. Technology has become a significant component of American shopping habits; e-commerce is supplanting traditional brick-and-mortar stores as the go-to retail experience. Everything from glasses and groceries to cars and houses — all products seemingly untouchable by e-commerce — are now compared and purchased regularly and increasingly online. This massive shift leaves physical retailers scrambling as purchasing power has transferred to the consumer.
The repercussions for retail real estate are formidable. Industry experts estimate that as many as half of the 1,100 U.S. malls will close in the next 15 to 20 years, driven primarily by the rapid rise of e-commerce. The first casualties will be class B or C malls, secondary or tertiary offerings in a specific geographic area. Retail real estate investors will need to focus on higher- quality assets geared toward experiential and e-commerce resistant shopping — high-quality retail mixed with service components such as entertainment and restaurants. Assets anchored by grocery as opposed to department or big-box stores should also weather the new economy shifts, as adoption of online grocery services is still limited and costly, providing a continued stream of foot traffic into physical grocery sites. Mixed-use space, which combines living, shopping, dining and other experiential offerings, is gaining traction as well. These changes in consumer trends have opened opportunities for transforming assets to meet the revision of retail in the new economy.
MULTIFAMILY
The multifamily sector’s shift toward luxury, urban apartments located near amenities and transportation has become a defining theme of the new economy. However, this type of asset is reaching saturation, particularly in gateway markets. A growing number of millennials will soon begin moving to suburban locations — where development and supply has been scarce — to more affordable apartments to begin establishing families and connections in better school districts. This presents a compelling near-term investment opportunity in the multifamily space to target well-located suburban assets with the appropriate locational attributes to capture the shift of some millennials out of the urban core. Assets in proximity to urban-like amenities such as entertainment and dining, in preferred school districts and with access to a broad array of employment opportunities are well positioned to be acquired and transformed into assets with updated features, positioning them to compete effectively for renters in the new economy.
HOTEL
Hotel owners and operators have also been victims of the disruption from technological change and shifting user preferences in the new economy. Online travel agencies such as Expedia and Hotels.com have rapidly become a hindrance to hotel groups, now burdened with easy cancellations, significant fees and variable booking volume due to technology-
enabled price discovery. These forces are negatively influencing commodity properties, as pricing power and choice are firmly in the hands of consumers. Additionally, online home-sharing services such as Airbnb and VRBO have increased competition by providing a shadow supply of hotel rooms.
That said, pockets of demand driven by the new economy continue to exist. One theme that drives our hotel investments is the increased demand for experiential leisure travel. The new economy has featured increased consumer spending on experiences and, therefore, has disproportionately benefited hotels providing unique and interactive atmospheres to capture leisure travel. Within limited service hotels that cater to business travel, demand continues in markets that feature growing and diversified industries supported by a consistent and mixed revenue stream, which are generally less likely to be harmed by online home-sharing services such as Airbnb and VRBO.
CONCLUSION
The evolution of technology and evolving demographics is creating opportunities to capitalize on changing demand patterns for real estate investors through the upgrading of our physical infrastructure to meet the needs of the new economy. Today’s real estate environment demands a proactive approach to add value through diligent sourcing, de-risking and transforming real estate. A successful strategy also requires an understanding of real estate at a local level for each property type in a specific submarket. Further, the current later-cycle macroeconomic environment, defined by interest rate risk and higher potential growth, is well suited for an active and value-creation strategy. Given the significant opportunities available from the impact of technology and demographics on demand trends for real estate, a strategy focused on transforming real estate for the new economy should represent a defined allocation in real estate investor portfolios.
Chad Burkhardt and Jeffrey Reder are senior vice presidents of private real estate at CenterSquare Investment Management. This article is part of a larger report they wrote. To read the full report, go to: https://bit.ly/2vR7WsC