With lower costs of living and increased adoption of remote work, many Americans and corporations left large metropolitan areas for midsize cities in the past couple of years. ElmTree Funds, which specializes in industrial and build-to-suit assets, expects these migration trends to positively affect real estate fundamentals in growing primary and secondary markets.
James Koman, CEO & founder of ElmTree Funds, shared his views on the effects of the migration away from gateway markets on both industrial and office real estate.
How do you expect migration to play out in the U.S. in the coming decade?
Koman: During the pandemic, we saw an acceleration of the ongoing trend of population migration from gateway cities to growing primary and secondary markets. We expect this trend to continue over the foreseeable future.
First, primary and secondary markets often offer lower costs of living for employees, which we believe results in consistent population growth in certain primary and secondary markets. Second, we believe the lower levels of congestion and ease of access and transportation within primary and secondary markets are better suited for a hybrid work environment. Third, primary and secondary markets often offer lower costs of labor and more favorable business environments for employers relative to gateway markets, which we believe entices corporations to relocate to primary and secondary markets.
How will the office and industrial sectors be impacted by these trends?
Koman: For the office sector, we believe these population trends will benefit office properties situated in primary and secondary markets. With that said, we believe newly constructed, Class A office properties are best positioned to benefit from this trend. Well-located Class A office facilities feature characteristics best suited for a hybrid work environment, including extensive amenities, allowing corporations to attract and retain talent, COVID-19-friendly specifications, providing safe work environments for employees, and flexible workspaces with open floorplans, which accommodate a hybrid work model.
For the industrial sector, we believe the population migration from gateway markets will drive an increase in demand for distribution facilities in primary and secondary markets. As populations grow in those markets, e-commerce companies will be highly incentivized to locate new facilities in these subject markets to achieve same-day delivery.
What are the implications of the hybridization of the workforce for office demand?
Koman: We believe the hybridization of the workforce will drive a bifurcation in performance within the office sector. More specifically, we believe Class A office properties feature unique characteristics, which position the sector to outperform Class B and C office properties within a hybrid work environment.
Additionally, Class A properties often meet increasingly stringent ESG standards, which outdated Class B and C properties fail to meet. As investors push corporations to lease properties meeting ESG standards and investors push landlords to invest in ESG-friendly properties, we believe demand for Class A properties will continue to increase both from a tenant and investor standpoint.
In terms of pricing, Class A office properties have also delivered valuation premiums relative to Class B and C properties as evidenced through high price per square foot metrics for several notable Class A office property transactions completed since the onset of the pandemic. We believe these transactions are representative of institutional investors’ increasing focus on Class A office properties more broadly, which should allow these valuation premiums to expand over a long-term investment horizon.
Even though office attendance remains well below pre-pandemic levels, Yardi Matrix has seen a rapid recovery in apartment demand, as well as occupancy and rents in urban CBDs over the past 12 to 15 months. What does that say about who is returning to urban downtowns and why? How do you expect this return to impact office demand in urban core areas?
Koman: We believe certain urban submarkets will continue to perform well in a post-pandemic environment. We believe the regions that experienced significant population growth during the pandemic, such as the Southeast region, will continue to see robust performance in certain urban submarkets. For example, we have seen positive fundamentals in urban submarkets in Orlando, Fla., and continue to see heightened tenant demand for Class A office product in that market. We believe Orlando is a quality example of a market that has a growing, young, educated population base, attractive transportation infrastructure, and a general live-work-play environment that can function well in a post-pandemic world. Conversely, we think urban submarkets within gateway markets that are struggling with low occupancy and inefficient transportation infrastructure, will likely struggle moving forward.
Which cities/regions are seeing improving office market fundamentals today, and which areas are underperforming as a result of migration?
Koman: Primary and secondary office markets averaged higher annual rental growth compared to the modest rental growth experienced in coastal gateway office markets as of Q1 2022. Over the same period, growing primary and secondary markets, such as, Orlando and Fort Lauderdale, Fla., and Raleigh, N.C., experienced above-average office annual rental growth, while coastal gateway office markets, including San Francisco, New York City and Washington, D.C., saw rents contract.
What are the regional implications of migration away from gateway markets for industrial real estate?
Koman: We believe the Southeast and South Central regions of the U.S. are best positioned to benefit from the population migration away from coastal gateway markets toward growing primary and secondary markets. For example, we have seen significant industrial activity occurring in the Carolinas, as college graduates from the surrounding high-profile universities are choosing to stay in the region rather than relocate to gateway markets.
We believe similar trends will result in larger population bases in these Southeast and South Central markets moving forward. As a result, we anticipate that more corporations will increase their leasing activity in industrial assets in the area in order to establish the supply chain infrastructure required to provide same-day delivery to these markets.
Which industrial markets in the U.S. have benefited the most from the latest migration patterns?
Koman: Two examples of Southwest markets that have experienced strong population growth and increasingly positive industrial fundamentals are Salt Lake City and Phoenix. Both markets experienced double-digit rental growth over the past 12 months as of Q1 2022. Similarly, we have also seen positive trends in the southeast region. For example, the Nashville, Tenn., and Tampa, Fla., markets have experienced strong population growth along with industrial rental growth of over 10 percent.