The Urban/Suburban Office Cap Rate Spread
By: Brian Moosburner, CFA, investment officer, Metzler Real Estate
How technology companies and the changing role of technology are affecting the cap rate spread between urban and suburban office properties.
Late 2009 was a defining moment for office investors. After almost two years of declining transaction volumes and falling values, investment activity gradually turned up. Coming off of a sharp recession and persistent economic uncertainty, many investors favored major urban markets that were perceived as safe havens for the risk averse. One theory was that large central business districts in cities such as New York City and San Francisco were locations where relatively healthy levels of employment would support real estate demand. Suburban markets, on the other hand, would be much riskier and more volatile until the economy improved further.
This shift was quickly reflected in capitalization rates. There had always been a risk premium between urban and suburban office assets, but by the middle of 2010 this spread was approximately double the historical average, reaching 150 basis points, according to Real Capital Analytics. Fast forward to the beginning of 2015, and all signs point to what should be a shrinking risk premium. Economic growth has been surprisingly firm and the unemployment rate has dropped from 10 percent in October 2009 to 5.7 percent today. Office investment activity is brisk. Office-using job growth is expected to outpace overall job growth for the foreseeable future. However, the divergence between urban and suburban office capitalization rates is only slightly less than it was in 2010. What is going on? Can this trend continue?
The Role of Millennials and Technology
Although various factors play a role, the much publicized demographic of tech-savvy millennials appears to have a lot to do with this phenomenon. The impacts of this influential population’s entrance into the workforce, companies’ efforts to recruit them and their divergence from past generational norms of driving and household formation cannot be overstated. Yet related trends explaining the preference for urban locations get less attention. As discussed below, these other trends are a bit circular, in that they all point back to a rapid evolution of technology and technology-oriented employment that has become more apparent during just the last five years.
To start, consider how relatively strong technology employment has been in recent years. According to JLL, 19.1 percent of all office employment growth between 2009 and early 2014 was in high-tech fields, compared to only 14.1 percent between 2003 and 2007. These positions include software developers, system analysts, web developers, information security analysts, database administrators and countless others hatched from the increasingly interconnected world of digital information. These growth figures capture the “technology jobs” of those working at typical tech firms such as Google, Apple and Salesforce, but likely understate the broad and growing influence of technology employment across all businesses and sectors.
As technology employment has continued to experience outsized gains in an otherwise modest economic recovery, where technology employers are choosing to locate is also undergoing rapid change. Historically, some of the largest and most recognizable technology employers were located on suburban campuses in California’s Silicon Valley, Boston’s Route 128 corridor, the Research Triangle of North Carolina and the suburbs of Seattle. Now, technology employers are more likely to cluster together in dense, urban areas such as Midtown South in New York City, South Lake Union in Seattle and South of Market in San Francisco.
According to the Brookings Institute, this clustering “not only eases resources, goods, and labor sharing, but also enhances innovation.” This is especially important from an employer’s standpoint, as one study from the American Economic Review showed that doubling employment density increases average productivity by around 6 percent. Employees also see a benefit, since concentrated urban pockets of employment density provide a broader pool of job options and greater flexibility.
The Changing Nature of Technology
Another factor is the changing nature of technology itself. Over time, the high-tech industry has become less focused on space-intensive semiconductors and computer hardware. It is now driven by the Internet, cloud computing and smartphones. This shift is well suited for urban environments, where a diverse pool of human capital can quickly congregate and collaborate on different ways to digitally deliver content, sell products, play games and simplify both ordinary and extraordinary tasks for individuals and businesses.
Furthermore, analysis by the Center for an Urban Future in New York City finds that many technology employers are now “applying technology to traditional industries like advertising, media, fashion, finance and health care.” This broadening of the technology spectrum highlights the importance of proximate location as an increasingly diverse client pool reinforces the need for various technology players to be close to the individuals and companies with which they do business.
What Will This Mean for the Future?
Investment capital has rapidly picked up on these evolving trends, which helps explain why the cap rate spread between CBD and suburban office product is well above its historical average. It remains to be seen if this is a temporary entry point for suburban investors to earn attractive risk-adjusted returns or a more permanent recalibration of risk between urban and suburban locations. History suggests that tenant preferences are cyclical, and the next generation of office users may have a different set of priorities. Either way, suburban high-tech office buildings are not likely to disappear. Many companies will still need (or prefer) large footprints in suburban campuses for various uses that don’t make sense in urban locations. What risk premium investors assign to those assets and what they are willing to pay is an entirely different question.