By: Paul Leonard
As the capital markets cycle matures, underwriting profitable investments in both Core Coastal(1) and Sun Belt(2) markets is becoming increasingly more difficult. If you miss the days when the first digit in your pro forma cap rate started with a 7 (or higher) and you are willing to pursue a yield-driven, buy-and-hold strategy, I’ve got two words for you: Rust Belt.(3)
Now, after the visions of municipal bankruptcies(4) and rivers on fire(5) stop dancing in your head, please hear me out.
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Sure, the best years for this region may have long since passed, and although manufacturing is coming back, it will not likely be the driver that it was decades ago. But even in the absence of an economic renaissance, there are still pockets of wealth today that are comparable to some of the best neighborhoods in the Core Coastal markets -- and have vastly lower supply risk than most Sun Belt markets.
Detroit, St. Louis and Cleveland -- while not exactly considered the belles of the CRE ball -- all three have distinct wealth belts (see Exhibit 1) where the median disposable income exceeds $60,000 and in some cases even $80,000 per year.
These figures are not insignificant. Just 5% of U.S. zip codes exceed $60,000 per year and less than 2% exceed $80,000 a year.(6) And let’s not forget that the cost of living is much lower than the national average in Detroit (16% less), Cleveland (9% less), and St. Louis (7% less).
Take Detroit, for example. Head honchos at the car companies have to live somewhere … and they do! There are pockets of wealth scattered throughout the metro, with the largest concentration located to the northwest in Oakland County.
Now the question for property investors becomes: What to invest in?
The retail property type naturally lends itself to exploiting micromarket demographics, since retail landlords are much more concerned with the asset’s immediate trade area than the metro’s overall economic performance. Retail assets are also the most commodity-like, both in terms of their physical build-out and the national and regional tenants that a quality center typically attracts.
Again, taking the Detroit example, there are many thousands of executives and white-collar workers who can support high-end retail. Top national retail tenants are aware of these strong demographics, as evidenced by Microsoft’s plans to open a store this fall at the Somerset Collection in Troy. Already, three out of four Whole Foods in the metro are located in southeast Oakland County.
Growth is never going to be a strong point for Detroit or other Rust Belt markets (see Exhibit 2 below). But the risk of supply is also mitigated by the negative national perception of these markets, which likely limits future competition to high-quality but second-generation shopping centers.
While there is little impetus for growth, opportunistic investors will liekly be compensated handsomely in the form of sky-high yields. Of course, the downside to an investment in the Rust Belt markets is the acute liquidity risk that comes with the stigma.
(1) Core Coastal markets include: Boston, East Bay, Los Angeles, New York, Orange County, San Diego, San Francisco, San Jose, Seattle, and Washington, DC.
(2) Sun Belt markets include: Atlanta, Austin, Dallas, Fort Lauderdale, Houston, Jacksonville, Las Vegas, Miami, Orlando, Palm Beach, Phoenix, San Antonio, and Tampa.
(3) Rust Belt markets include: Cincinnati, Cleveland, Columbus, Detroit, Indianapolis, Kansas City, Milwaukee, Pittsburgh, and St. Louis.
(4) “Billions in Debt, Detroit Tumbles Into Insolvency,” New York Times, July 18, 2013.
(5) Cuyahoga River Fire.
(6) Per ESRI data as of 2012.
Paul Leonard is a real estate economist with CoStar Group.
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