When millenials begin to flock to cities such as Nashville and Austin, Texas, in search of higher-paying jobs and a lively cultural scene, real estate development followed. According to Dave Bragg, managing director and research analyst at Green Street Advisors, investors in those markets won’t produce the returns the companies are seeking.
We recently spoke with Bragg about land-use regulations, demographics and supply constraints in certain sectors and markets.
Q: Some of Green Street’s recent research defies traditional wisdom regarding the perception that favorable demographics almost always guarantee outsized growth in certain sectors. Can you elaborate?
A favorable demographic outlook frequently results in outsized demand in the majority of property sectors and markets. This clear demand-driver frequently compels investors to underwrite outsized NOI [net operating income] growth for their acquisitions and developments expected to benefit from a demographic tailwind.
Our analysis shows that based on the top 50 markets with properties across sectors, that most of the demographic trends that are easy to see coming won’t end up mattering that much. In other words, favorable demographic trends are certainly desirable, but they don’t have much of an impact in most cases.
One demographic trend focused on by investors is the aging of the population. The reason that this trend doesn’t end up having a large influence on NOI growth is because developers generally react quickly to keep pace with demand because supply constraints are limited for the majority of sectors and markets.
Demographics do not guarantee outperformance. Property investors are advised to consider that demographic-driven demand growth is not a factor in most cases, but it matters a great deal when meaningful barriers to entry exist or when growth is negative.
Q: Your research provides some case studies on why favorable demographics don’t always equate to outperformance. Can you give an example?
A great example is the recent performance of Austin, Texas, apartments. It is easy to see why Austin regularly leads rankings of the best places for millennials to live, work and play. The weather is warmer than in the Northeast, and the housing is more affordable than California. A well-regarded university, the Texas State Capitol and the “Silicon Hills” tech scene make Austin a compelling place to kick-start a career. Outdoor activities, great food and vibrant nightlife in the “Live Music Capital of the World” ensure a good time too.
These attributes have caused Austin’s growth of 25-to-34-year-olds to soar, most of whom rent versus own their property. Here, terrific demand growth influenced investors, as much of the local apartment acquisitions were underwritten in this decade. However, developers took note of the same trends and flocked to town, shovels in hand. Conversely, with the absence of meaningful supply barriers, Austin’s inventory grew at nearly three times the national rate, resulting in below average RevPAF(revenue per available square foot) growth.
Q: The sectors that you indicate will see the most significant long-term growth feature strong demand and good demographics, but are also supply constrained. What sectors will be leaders and laggards based on this theory?
At the sector level, only age-restricted manufactured housing will clearly benefit from favorable demographics. Demand will surge over the next two decades as baby boomers retire to high-quality, age-restricted communities. Nonexistent inventory growth is attributed to NIMBYism (not in my backyard) as locals frown on the idea of neighboring “trailer parks.” Long development stabilization periods and highest-and-best-use alternatives are also impediments. As a result, manufactured housing is the only sector in our sector allocation framework that receives a favorable demographic-related adjustment to historic NOI growth. Manufactured housing has long screened as the most attractive sector in our proprietary sector allocation framework for both public and private market investors, and that remains the case today.
On the other hand, a laggard is the student housing sector. The weak outlook for student age population growth warrants a negative adjustment to the sector’s historical growth rate in our sector allocation framework. Separate considerations include a leveling off of the share of the student age population enrolled in college and the potential threat from online education already considered as a technological disruption adjustment. Little-to-no supply constraints are evident off- campus as inventory growth has surged in recent decades. The negative demographic adjustment would be more punitive if not for the REITs’ high-quality assets, including on-campus public-private partnerships requiring complex university relationships.
Q: You cite land use regulations as the primary impediment to new supply in “gateway” markets. However, your research implies that these marketplaces suffer from the misnomer of being “supply-constrained.” Can you clarify?
A popular private and public market property investment strategy centers around “high-barrier” markets where land and cost are perceived as constraints on new supply. But a focus on these factors ignores the biggest impediment to supply growth: land-use regulation.
Our recently introduced proprietary regulatory-constraint framework considers the incentives and influences of residents and cities in an effort to separate markets that are truly supply-constrained from those that aren’t. The NIMBY desires of residents have greater influence in markets with high population levels relative to commercial property inventory. For example, state and local factors exacerbate NIMBYism in California. Another example is a city’s need for and dependence on property tax revenue which influences permitting. Transportation infrastructure is another consideration. Competition from surrounding areas is mitigated in metros with poor intra-market mobility.
In our new framework, New York’s regulatory environment renders inappropriate the “high-barrier” label that is often applied to the market. A recent rezoning of wide swaths of the city is likely underappreciated. By contrast, West Los Angeles’ high barriers are daunting. The public market and our outlook suggest that West LA is more favorably priced in the private market than New York. Property investors mindful of major regulatory inflection points will possess an underwriting edge in these cases.
Q: What types of strategies have you seen investors employ in order to succeed in constrained markets?
Developers who are most successful in the few markets that are truly supply-constrained are patient and experienced. An example is the apartment REIT AvalonBay Communities, Inc. (NYSE: AVB), which builds in sub-markets of Boston, New York and elsewhere where it is difficult to attain local approval. The company employs highly experienced personnel who are capable of navigating the local zoning and permitting process.
Dave Bragg is a managing director and research analyst at real estate research firm Green Street Advisors. He focuses on strategic research on topics across property sectors in the public and private markets.