American Realty Advisors: Suburban to the Core

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Institutional investment-grade property is no longer only to be found in cities.

Suburban to the Core

by Stanley L. Iezman

REPRINTED FROM REAL ESTATE YEARBOOK, A SPECIAL PUBLICATION OF INSTITUTIONAL INVESTOR, OCTOBER 1989.

The strategy of acquiring core urban properties is rapidly changing with the "horizontalization" of America. There are many reasons why a suburban investment strategy should now be considered.

Real estate as an asset class for investment by pension plans has traditionally been structured to provide an investment portfolio with value enhancement, yield stability and a hedge against inflation. Institutional investment-grade core property has been traditionally defined as those assets in macro and micro markets which are economically diverse, completed and substantially leased, occupied by major business interests, consistent with alternative investments in terms of yield, and which have a significant user demand resulting in a stable income flow and rate of return.

The real estate investment industry thus came to define core assets as "trophy" office properties in urban areas, along with regional retail centers in various markets. Yet today, the prudent investor who looks beyond the traditional definitions and location of a core asset will see that a multitude of product types located in selected suburban markets throughout the U.S can and do fall within the core definition.

Lower Costs, Higher Yields

Any discussion of a Suburban market strategy must focus on employment growth by region and by industry classification, along with unemployment rates, vacancy rates, construction activity, absorption rates, the evolution of technology in business and, ultimately, the price of rent.

The cost of acquiring an urban office property, along with that of regional malls, has increased significantly as a result of a burgeoning foreign and institutional investment focus over the past ten to 12 years. In turn, this has pushed rental rates for office properties in the central business district and regional malls to a significantly higher level than those in suburban markets.

Lower land costs outside urban areas, coupled with lower construction and transaction costs, have accelerated the development of suburban office and industrial properties and neighborhood and community retail centers. Investors are thus able to acquire suburban properties at a lower cost per square foot with correspondingly higher yields and lower rental rates.

These new choices for corporate and noncorporate space users have become increasingly important as a means for corporate managers to increase profits. lower occupancy costs in suburban locations have allowed many companies to reduce their administrative costs by up to 40 percent.

Corporate Migration

Image, while very important to most public companies, is becoming secondary to profit. Citicorp, for instance, has sold most of its trademark building in Manhattan to a Japanese insurer and will reduce its rental cost by 50 percent by relocating its headquarters to a new tower in Queens. Sears, Roebuck and Co. is moving out of 1.2 million square feet of prime office space in downtown Chicago and relocating to the Hoffman Estates, a suburb north of the city. Merrill Lynch is relocating more than 2,000 back-office personnel to New Jersey. 'There are numerous other examples.

The vacancy rates in urban office properties, while traditionally lower than those in the suburban markets, are being driven upward as the absorption rates for space In the suburbs become higher than those in the urban core. In 1988 the amount of space absorbed in the suburban office market was approximately 65 percent greater than space absorbed in the urban market. The number of years of vacant office space for the suburban office market is approximately 1.5 years less than the inventory for the urban market.

Regional Distribution Bases

With the horizontal expansion of the population and housing base, the need to create multiple distribution points on a regional basis is becoming more critical. Distribution facilities can and must be located in areas central to their distribution base, but in lower-cost regions.

From an investment standpoint, suburban distribution facilities become more viable as a result of the in-fill of these regions. In turn, many companies that provide ancillary services are relocating their operations to areas surrounding these distribution and manufacturing points, thereby dramatically reducing the cost of transportation and the time associated with shipping.

A suburban asset can, in part, offer a lower investment risk than an urban asset. Core urban investment-grade properties typically sell at capitalization rates of between ,5 percent and 7 percent, while the same property in the suburbs will sell at capitalization rates of between 7.5 percent and 9 percent.

But this pricing differential also generates opportunities for competitive projects to be built and acquired in these suburban markets due to the fact that the per square-foot cost associated with the suburban asset is lower than that of the urban asset. Office buildings in the CBD will command a price of between $200 and $400 per square foot, while office buildings in the suburbs command a price of between $100 and $225 per square foot.

If one incorporates a long-term view of the suburban rental market, one can see that there is potential to increase the rental rates of suburban office and office "service center" properties at a greater rate than urban properties, as demand for such lower-rent facilities increases.

The regional shopping center is also experiencing the effects of higher rental rates, a direct result of the higher prices paid for these facilities. Discounting, off-pricing, specialization and the like have led the retail market into lower-cost and thus lower-rental-rate community, neighborhood, strip, mixed-use, specialty, theme, underground and mini-mall facilities. This transformation has allowed for greater spillover to occur in the suburban market.

In Search of Labor

Another issue that is increasingly affecting corporate decisions about locating company headquarters is the infrastructure within the urban market. Private and business citizens alike are concerned about gridlock on deteriorating highways, inadequate growth management, an education system at capacity, water shortages, decaying bridges and other factors.

The decline in the real growth of finance, insurance, real estate and service sector workers - coupled with a decline, in absolute numbers, in the work force as a result of an aging baby-boom generation - will also have an impact on the urban office property market. labor-sensitive businesses must seek out a labor pool that has already migrated to suburban markets.

From a labor standpoint it is important to note that there is a trend toward higher employment growth in many standard industrial classifications now located in the suburban markets. In addition, the unemployment rate in many of these suburban markets is lower, the educational level is higher and the work ethic is stronger.

A suburban real estate strategy ultimately focuses on increased growth and in-fill, which increases rental rates and, consequently, yield. But it also looks to the acquisition of assets that are flexible, allowing owners to attract alternative users as the market and demands for space change. This is critically important in the suburban market as we move into the 1990s.

While most institutions have focused their investment criteria on core trophy assets located in urban areas, those properties may become less viable investment alternatives. Without a major rebuilding of our urban areas through public and private efforts, the migration to the suburban marketplace will continue. It is important, therefore, that the institutional investor begin to reformulate the definition of "core" to include different product types located in the suburban market.

Stanley L. Iezman is President and Chief Executive Officer of American Realty Advisors. He is an adjunct professor at the University of Southern California's School of Urban and Regional Planning, where he teaches real estate asset management. He is the chairman of the New York University Real Estate Institute's Annual Symposium, "Pension Plan Investment in Real Estate," and is a published author and lecturer.

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