Unsustainable: Is New York Now Really 1/3 Of Aggregate American Office Real Estate Value?

Posted: May 16, 2018 9:48 AM
Unsustainable: Is New York Now Really 1/3 Of Aggregate American Office Real Estate Value?

Cap-weighted Real Estate Investment Trusts allocate roughly 1/3 of their capital in New York. This might make sense if 1/3 of the business value was being created there, but it isn't. If the share of real estate value in a particular metro area exceeds the share of wealth creation, that suggests that the real estate in that metro area is overvalued. Think of it this way: The ability to pay office space rent (or to buy office buildings outright) is contingent on the earnings from the business doing the renting (or buying). In classical economics, the value of land is the discounted capitalized value of the wealth to be created on that land.

But do markets perfectly capitalize that value? Of course not. Did markets perfectly capitalize the future earnings of Pets.com in 1999? Of Enron in 2000? Markets can be wrong. What happens when real estate costs exceed value creation is that businesses in the overvalued market underperform financially. Eventually they either cut costs by moving to a lower-cost region or they are outcompeted by those who manage their costs more diligently.

This does not imply that businesses must and will always move to the lowest cost cities. Some cities lack the basic building blocks of high-productivity work. They might not have highly skilled labor forces, or access to lucrative markets, or adequate information or transportation infrastructure. No price is low enough for a high-value-added business to move into the middle of nowhere. But that does not mean that responses to real estate costs are infinitely inelastic either. There are such things as unaffordable prices even for the world's most profitable business concerns. And when prices in certain cities are so high that a price-based cap-weighted real estate index shows New York, Boston, and San Francisco holding a majority of all office real estate value in America, things look like they've gotten increasingly unaffordable. At least, this suggests very limited upside for commercial real estate in those cities. It’s likely suggesting even more: The probability that real estate price arbitrage will push business activity out into places other than those three cities, to markets in which real estate costs lag behind business value creation. I'm talking about places like those you see below, in mostly flyover areas such as Baltimore, Atlanta, Chicago, Philadelphia, San Jose, Austin, and Seattle.

There are signs that this has already begun. A recent survey says that New York is one of the top 3 states for population outflow.

A plurality of those leaving did so for job reasons. That's business space that they are no longer occupying in New York (likely mostly the city, because that's where people disproportionately live) and now occupying elsewhere. The numbers are already telling the story. The principle of inherent value (valuation) is not, and never was, just for stocks. It applies to any form of investment. You pay for future earnings, whether it's dividends or lease payments. The more you pay for the same revenue stream, the harder it is to make a good return.

For a deeper dive on approaches to real estate investing without the pro-bubble biases of cap weighting, click here.