Six Drivers for Tomorrow’s Hot Cities

By Amanda Marsh

While U.S. gateway cities will continue to be popular among commercial real estate investors and developers, the next decade will experience a shift for many into second-tier and interior markets. PwC and the Urban Land Institute first highlighted this movement in the 2015 “Emerging Trends in Real Estate” report, noting, “No longer is it accepted that only the great coastal cities can be alive around the clock and on the weekends.”

These downtown transformations had combined the key ingredients of housing, retail, dining and walk-to-work offices to regenerate urban cores, the report said, spurring investment and development and raising the quality of life in a number of cities.

Over three years, smaller markets have been replacing gateway cities on the report’s Top 10 U.S. Markets to Watch list, for which investors and developers rate potential among 78 cities, according to Anita Kramer, vice president of the ULI Center for Capital Markets and Real Estate. This year, only two traditional gateway markets made the top 10: Los Angeles at No. 5 and San Francisco at No. 10. Rounding out the top markets, in order, were Austin, Dallas-Fort Worth, Portland, Seattle, Nashville, Raleigh-Durham, Orange County and Charlotte.

“What is it about the smaller markets attracting attention?” Kramer asked. For investors identifying the best markets to target, six qualifications stand out.

1. Job and Population Growth

The nation’s population continues to grow, with 325 million people living in the U.S. now and as many as 400 million by mid-century, according to Dr. Hugh Kelly, special advisor to the Fordham Real Estate Institute at Lincoln Center.

“Immigration trends will affect that a lot, but the anti-immigrant policies being put in place are temporary—they’re not going to last, and there are good labor force reasons for that,” he said. “We will not have enough workers to grow the economy unless we have immigration of one million people per year.”

Immigrants by and large will move to cities, he continued, and this means the need for additional housing, public services and service-based jobs. “Despite the ‘America first’ attitude, you can’t turn the tide on globalization,” he said. “Economically connected cities will create the greatest number of jobs.”

Growth markets based on employment expansion include Seattle, Denver, Las Vegas, Silicon Valley, Chicago, Charlotte and Nashville, said Robert Bach, formerly director of research – Americas for Newmark Knight Frank. He also pointed to markets like Dallas, Austin, Orlando, Atlanta, Raleigh-Durham and Phoenix as offering rapid population and employment growth with somewhat higher cap rates, providing good prospects for further growth.

2. University Presence

A strong university presence—particularly where industry has partnered with academic institutions—is increasingly vital, contends Heidi Learner, chief economist for Savills Studlley.

“The ‘university effect’ is certainly one reason that areas like Raleigh, Phoenix, Atlanta and Austin are doing well,” she said, noting affordable cities with a strong research university presence, like Pittsburgh, can benefit despite lacking the industry concentration larger cities like New York have.

These cities also have more vibrant economies, because students create street life and retail, Kelly added. And it’s just as important to work hard on K-12 education for long-term growth.

REIS senior economist Barbara Byrne Denham warned cities must have a solid government that will nurture and retain the community schools have built. This is especially important in cities with graduate schools, as those students are more likely to join the local workforce.

3. Millennial and Baby Boomer Preferences

“Millennials will always be looking for the next big thing,” Denham noted. “And that may be more interior cities that offer a high quality of living and amenities. While they’re not by the ocean, they’ll offer features like mountains and lakes.” She listed Denver and Phoenix, and “perhaps even the Great Lakes.”

The lack of household formation by younger adults will help those markets’ multifamily sectors, according to Learner. The fraction of older Millennials, ages 25 to 34, bucking homeownership has continued to rise. And while the labor market has recovered, debt loads will continue to limit homeownership.

Meanwhile, Baby Boomers may also support interior cities as more age in place near their children and grandchildren. “People are healthier, living longer and living more active lifestyles,” Kelly said—and they are also working longer, as they are nervous about retirement funds.

Furthermore, Phoenix has become less attractive to retirees over the past few years as it has grown expensive again, as have Las Vegas and Sacramento, Denham said. Instead, Albuquerque and Santa Fe will be sleepers for this group due to their low cost of living.

Other options with a more temperate climate include North Carolina, Nashville and Atlanta. Climate change may even work in favor of some places that are warmer than they used to be, such as New England.

“The question is, will (investors) be chasing higher quality or lower cost of living?” Kramer asked. “My guess is both, which is good news for more interior markets.”

4. Infrastructure and Transportation

Infrastructure and transportation play a huge role on the submarket level, Bach pointed out. One great example is Portland, Ore., one of the first midsize markets to build a light-rail system and implement an urban growth boundary to control sprawl. Denver is also aggressively building out its transit system and committed to smart infrastructure investment.

Another lesson we’ve learned in the past decade is that people don’t like to drive, noted Denham. So cities that allow people to forgo cars and instead take public transportation or bike to work will thrive.

Nearby access to major cities will also be helpful from a residential point of view, noted Learner. This is attracting companies to places like Jersey City and Newark near New York City.

But many cities still suffer from infrastructure deficits. “Cities and states must be willing to tax themselves, and the ones that don’t will fall behind,” Kelly warned. “Contrary to belief, low taxes are a race to the bottom in the long term. Companies will go where the profit potential is, not because of low cost.”

5. Industry and Technology

It’s impossible to ignore the impact of e-commerce, which will make major metros with proximity to population centers increasingly important, Learner said.

“We tend to think of New York as the center of everything, but the median point for U.S. population is in Indiana—one reason a lot of distribution centers are developing in the area,” she noted.

Demand for distribution and fulfillment centers is off the chart, particularly in the Inland Empire, Dallas, Atlanta, Chicago and Northern New Jersey, as well as some smaller markets such as Indianapolis, Louisville and Cincinnati, Bach added.

Technology will also continue to propel many markets, he continued, noting that a number of smaller markets are developing small technology ecosystems, among them Indianapolis and Salt Lake City.

6. Long-Term Vision

On the sleeper side, Kramer pointed to Minneapolis, Indianapolis, Pittsburgh and San Antonio, whose governments have a long-term vision for the cities and are taking steps to make themselves more livable and walkable. Other surprising contenders are Charleston, Knoxville and Baltimore.

One unexpected returning market is Grand Rapids, Mich., where manufacturing and the auto industry are growing again, Bach said. Other interior cities he’s watching include Columbus and Cleveland; despite low population growth and modest job creation, they have restructured their economies and offer opportunities for investors and developers.

However, cities must be careful how they grow, Kelly warned. “Houston did a tremendous job of coming into a fully developed downtown, as did Dallas—but sprawling into the suburbs has diverted a lot of energy from their downtowns, and they’re competing with themselves instead of concentrating strength,” he said. “Phoenix is also its own worst enemy.”

Originally appearing in the June 2017 issue of CPE.