DOWNTOWN VS. SUBURBAN RENT GROWTH

The following article published by Torto Wheaton Research, a subsidiary of CBRE (CB Richard Ellis) compares rent growth, vacancies and returns for office developments in downtown and suburban Chicago and draws some interesting conclusions

October 12, 2007

DOWNTOWN VS. SUBURBAN RENT GROWTH – THE CASE IN CHICAGO
 
by Umair Shams, Economist
ushams@tortowheatonresearch.com
 
 In trying to obtain the highest returns, real estate investment funds often have to consider whether to narrow their search to downtown or suburban areas. It might seem that because of higher occupancy rates and relatively higher rent levels, Downtown areas would easily win out. As attendees of TWR’s Client Conference found out last month, however, these apparent advantages do not always translate into higher rent growth over a long time period of time. Moreover, Downtown areas have a higher exposure to cyclical real estate patterns, so their rent growth tends to be more volatile.

Vacancy rates in the downtown (CBD) areas tend to be lower due to supply constraints. Looking at national data going back to 1988, however, downtown rent growth has been no higher than suburban. Applying rent growth analysis to different metro regions will not always produce the same results; in some cities downtown rent growth has been higher on average and vice versa. In cases that mirror the national figures, however, rent growth can actually be very close between the Downtown and Suburban. When that happens, the next logical question for investors to ask is “where is the risk greater?”

Analyzing TWR historical data from 1988 to 2006, one finds that Chicago falls into the category where average annual rent inflation has been the same for both suburban and downtown office buildings; at 1.5%. Note that the period covered in this analysis includes two economic downturns, in the early 1990’s and early 2000’s. However, unlike the national data, which showed vacancy rates were mostly lower than suburban rates, vacancy rates in downtown Chicago were not always lower than suburban rates. Six out of the 19 years (1993 to 1998) suburban vacancy rates were in fact lower than downtown vacancy rates. Interestingly, average annual rent growth in the suburbs for the same time period was higher, at 7.4%—compared to a downtown average annual rent growth of 5%.
 
Chicago Area Vacancy Rates
 
Of course similar returns do not mean that investors can be indifferent to holding assets in either area. Looking at the standard deviation of both areas to get a sense of rent volatility, suburban Chicago’s rent growth numbers recorded a standard deviation of 5.78% compared to downtown Chicago’s 7.90%. This can be explained in that, while Chicago’s downtown is supply constrained in the sense that it is difficult to put up new buildings, the long lead time required can mean that new buildings often wind up completing at a bad time for the market. So although lower vacancy rates and higher level rents may have made buildings in CBDs tempting to investors, they were exposed to more volatility while yielding only the same average rent growth. Investors that bought and held for an extended period would have been better off holding suburban assets, which would have given the same rent growth, but with lower risk. There are periods, such as the later part of the last expansion, where downtowns were indeed the location to invest in for superior rent growth.

So, while real estate has always emphasized location, location, location, even this dictum needs to strongly take into account timing as a factor. The higher volatility in downtown markets, found in Chicago and nationally, means that downtowns are less an invest-and-hold option than one in which to be keenly aware of the market so as to better time your entry and exit.