Investors Trended Toward Suburban Office, Apartments In 2020, But It Might Be A Blip

Investment capital ebbs and flows into commercial real estate, according to the economy and a multitude of other factors. During 2020, capital aligned itself with new investor priorities, especially as they looked for office and apartment assets.

Investment volume as a whole dropped in 2020, and especially in sectors such as retail and hospitality, Newmark reported in its Q4 2020 Capital Markets report. Even so, investors showed renewed interest in office and multifamily product away from gateway cities — often in urban locations in the case of office product, but definitely in the suburbs for apartments and some office. 

Despite the coronavirus pandemic, office properties as a class still excites investor interest as they look to the long term past the current crisis.

"Many large institutional money managers showed conviction that a return to the office will come with the pandemic recovery," Reonomy Market Analyst Omar Eltorai said. "Looking across investment activity of over 30 large institutional investors, in 2020 about 43% of all CRE investment dollars went into the property type."

Historically, Eltorai said, these institutional money managers put closer to 34% of annual investment dollars toward office, so that means that they allocated more into the property type during the pandemic than they have in the past.

Further, 2020 saw the highest share of capital allocation to non-major markets on record, at 75.8%, according to Newmark. Last year merely capped an ongoing trend, however, because in recent years CRE investors have been inching toward smaller markets. Investment into non-major markets has increased 13.9% over the last five years.

“Investors in office properties have been interested in 'secondary' metros for quite some time," said Martha Peyton, managing director of real assets applied research at Aegon Asset Management. "While the primary markets were the focus following the last recession, attention expanded to fast-growing secondary markets with attractive growth drivers especially related to tech."

Secondary market returns were quite attractive in 2020 for office properties, especially in secondary-market suburbs, though some major city centers did reasonably well. The best returns in 2020 in urban office properties were in Atlanta, which topped an average of nearly 5.5%, Newmark reports, while in Charlotte, North Carolina, and Seattle, urban office property returns were between 4% and 5%.

Suburban office properties turned in better returns than those in city centers. In Boston, Charlotte and Raleigh/Durham, North Carolina, 2020 office property returns were over 8%. The San Diego, Seattle and Denver suburbs each posted returns between 6% and 8%.

"The pandemic is expanding interest in secondary markets due in part to the disadvantages of the high density and public transit dependence of some primary market downtowns," Peyton said. 

But the pandemic has also had the effect of stalling transaction activity in office property overall, which makes it impossible to gauge how much values might be changing, she said.     

"Nationally, the sale of office properties in central business districts made up only 33.3% of all office transactions in 2020," said Jimmy Hinton, Newmark's head of investor strategies. "Investors enthusiastically competed for urban office investments, provided the property featured low vacancy and long-duration weighted average lease terms. Suburban office transactions, on the other hand, increased as a share of overall office property sales to 66.7%."

Uncertainty surrounding pricing for office assets also drove an avoidance of large-scale transactions, which had an outsized impact on CBDs because of their concentration of large-ticket assets, with CBD investment volume declining more than suburban office investment in 2020, said Jacob Rowden, JLL analyst, national capital markets research.

“In 2020, we saw investors in U.S. real estate favoring the suburbs," CBRE Global Chief Economist Richard Barkham told Bisnow in an email. "This happened in two ways. Metros with more suburban development, such as L.A. and Dallas, outperformed markets like New York City in 2020, and within the same metro, more capital flowed to suburban areas versus CBD." 

For example, more than 60% of investment in metro New York took place outside of Manhattan, Barkham noted, with a similar trend in Washington, D.C., and San Francisco.

"There is no evidence to suggest this is a long-term trend, and as the big cities open up over the course of this year we expect normal patterns of real estate investment to resume," Barkham said. "Investors have a lot of capital to deploy and no stone will be left unturned.”

In 2021, Newmark likewise expects urban investment in office product to increase, Hinton said. Office tenant demand was sporadic in 2020 across the nation, but with the distribution of COVID-19 vaccines and resulting improvement in office-using employment in many markets, tenant demand should be more evident. 

"With more data points, investor consideration for acquiring urban properties will likely improve, especially given that yields in those markets are increasingly attractive, relative to targeted returns," Hinton said.

Investor interest in apartment markets also shifted in 2020, according to Newmark, though the patterns were different than in the office sector. Still, some of the drivers were the same, especially a pandemic-related urge to leave dense areas.

Multifamily transactions were concentrated in suburban markets for two main reasons, proven tenant demand and available investments brought to market by exiting merchant builders, Hinton said.

"Late-cycle development pipelines gravitated to suburban submarkets due to lower construction costs and tenant demand," Hinton said. "Naturally, those two dynamics resulted in suburban transactions comprising approximately 90% of multifamily transactions in 2020. We expect this trend to continue in 2021."

Multifamily returns were somewhat muted in 2020, with a few exceptions. In Salt Lake City, apartments as an investment class posted 12% returns, while Phoenix returns were about 10%. No other markets came close, with typical returns between 3% and 6% for the top markets for returns -- none of which were places like New York, Chicago or Los Angeles.

"Multifamily properties in the suburbs are becoming more attractive for reasons beyond the pandemic," Peyton said. "Millennials delayed marriage and children but are catching up as they mature. That means a need for more space and a tilt to the suburbs which offer larger apartments versus downtowns.”

Eltorai explains that investor interest in apartments, as in office properties, has seen some shift to secondary markets.

"Before 2020, the top five MSAs accounted for about a quarter of total multifamily sales volume annually," Eltorai said, referring to New York, Los Angeles, Chicago, Dallas and Houston. "During the pandemic, these large markets began to lose share to smaller MSAs." 

Through 2020, about one-fifth of all multifamily transaction volume was in the top five markets, and in the fourth quarter of 2020, one-sixth of multifamily transaction volume was, Eltorai said.

The appetite for suburban apartments is likely to slow down a bit as the economy reopens, and there is some mean reversion or return to pre-pandemic normalcy, Eltorai said.

"Certain MSAs are likely to be impacted significantly more than others, based on the industries that comprise their local economies," he said. "Those with industries that can be done remotely with little disruption, along with a higher cost-of-living, will likely continue to see these outward migrations from the large city centers."