To paraphrase Bob Dylan, the times are changing, and fast.
In light of economic disruption, such as the Great Recession of 2008 and the rapid growth of startups in unlikely places, it’s easy to think that the economic center of gravity has shifted from the coastal metropolises of the United States to inland cities. It’s easy to see why: after all, gateway cities are increasingly saturated, and as such, investors are turning to other, lesser-known towns in order to find (and capitalize on) the next hot market.
But the truth is far more complex: gateway markets are still a great investment, as they have retained their importance, their value, and more importantly, their profitability.
What is a gateway market?
In order to understand why gateway markets continue to provide robust investments, it may be helpful to begin with some of their key characteristics. According to some sources, a gateway city serves as an entry point into a country (either by air or sea), home to either massive container ports for cargo ships, or the site of large, extensive international airports.
However, this definition is flawed, as it is too limiting. By this token, very few cities–and none of our core markets–qualify. Instead, it’s more helpful to look at distinct qualities:
- Gateway markets have a high degree of liquidity, allowing for the easy, convenient trading of real estate investments.
- Gateway markets also have status. Cities like New York, Tokyo, or London are globally recognized, and have a strong, nearly untouchable brand.
- Gateway markets are economic and cultural powerhouses, and offer both opportunity and diversity. A city like New York, though best known for finance, also has a thriving startup community and a well-established, internationally-renowned fashion scene.
At Green Oak, we look at four key gateway markets in the United States: New York, San Francisco, Boston, and Los Angeles. Though one may think that these four cities are long past their heyday, and cling only to past glories, the truth may surprise you.
Why Gateway Markets Are Still a Strong Investment
At first glance, the argument against gateway markets is a good one.Essentially it states that gateway markets are now victims of their own success, with a wide range of problems, such as low yields (and a wide yield gap between gateway and non-gateway markets), saturation of markets, increasing competition, and decreasing returns.
It’s easy to subscribe to this belief, even if it doesn’t account for the whole picture. True, every day it seems that someone is raising a new core fund or a new Chinese investor is showing up. By August 2016, Chinese investors sank $12.9 billion into US commercial real estate, almost matching the $14 billion that was spent in all of 2015. Clearly, competition is stiff, and the market is daunting.
All the same, I’ve found that much of the capital is still focused on higher quality, stabilized assets–generally properties that are fully leased at market rates, with little turnover and minimal need for renovations. As a result, so long as you’re willing to do the hard work (such as sifting through the flood of investment opportunities or investing in improvements and modifications), there’s still money to be made.
Now the best way to find NOI value in a gateway city is to find something that’s broken, perhaps it’s underlet, has a bad capital structure for one reason or another, the landlord doesn’t have money (or isn’t willing to invest in tenant improvement). This is a variation on flipping properties (restoring, renovating, and improving developments before selling them off), and we’ve found that it works particularly well in gateway markets.
After all, once rent does go up, it always goes up first–and fastest–in gateway cities, namely because gateway cities have a huge barrier to constructing new supply. It’s impossible to build in cities like New York and San Francisco because everything’s already built up; to top it off, there’s incredibly strict zoning regulation, which makes it so that if you want to build something new, you need to buy it, tear it down, acquire the right titles and permits, get financing, and build it. This process is incredibly complex.
The case against secondary markets…
More importantly, in nearly 25 years of investment, I have never made money in a secondary market anywhere–even in China. Think about it: can any Americans name a secondary city in the United Kingdom, much less the United States? Few Americans (or for that matter, anyone who isn’t British) know little about the UK outside of London, other than a few other major cities such as Birmingham or Manchester.
But it goes beyond just name-brand recognition. The fact of the matter is that we haven’t made money in them. In fact, I would go so far as to say that secondary markets are classic value trap markets: they look cheap on paper and you can get a better spread early on (and enjoy a strong yield), but there are three key issues:
- Many of these cities, unlike gateway markets, don’t have a strong base of potential tenants. For instance, my partner and I are from Cincinnati and Nashville: neither city, I would argue, has a diverse, robust tenant market that would make our investments profitable in the long term. It certainly doesn’t help that both venture capital and talent are increasingly concentrated in large, usually coastal cities–like our gateway markets.
- Secondly, there are much lower barriers to entry, in contrast to gateway markets. Once rent starts to increase even a little bit, people begin building new assets and developing the area–which in turn leads to a glut of new properties, and thus, capping rent and leading to low liquidity.
- Lastly, who wants to be in a non-gateway market long-term? The Chinese investors aren’t going to Cincinnati or Nashville to buy up office developments or apartments. Instead, they’re going to places like New York and San Francisco–cities with the highest concentration of foreign investors. Why? Because gateway markets are incredibly valuable, long-term assets. Their value is nearly guaranteed to grow as time goes on.
Ultimately, gateway markets are still the best investment for real estate finance professionals. It’s easy to think that opportunities are gone and the market is saturated, but the truth of the matter is that mindset and strategies are essential, particularly for those investors who want to take advantage of the high-growth, stable, long-term market of gateway cities.