Investment research groups across the country have proven time and again that central business districts trump suburbs for apartment investment returns. That conclusion has guided an urban-centric strategy in recent years, yet it deserves a large, overlooked asterisk mark.
Within the nation’s core 50 markets, 88% of all apartment units are located outside of CBDs. That’s a massive group. Too large, we would argue, for meaningful analysis. A more useful analysis would break down the 88% into subgroups.
We did that using the NCREIF (National Council of Real Estate Investment Fiduciaries) database of apartments owned by institutional investors, and the results might be surprising: “Good suburbs” (defined later) roughly matched CBDs for total investment returns over multiple cycles. Additionally, “good suburbs” topped CBDs for risk-adjusted returns and ranked among the very healthiest subcategories of all commercial real estate tracked by NCREIF. The results were presented at the NMHC Research Forum on April 1.
MPF Research’s analysis of the NCREIF data follows our previous study of apartment operations data. The study showed that the best suburbs also matched CBDs in terms of apartment rent growth and occupancy rates over multiple cycles. It also showed that, counter to conventional wisdom, resident retention rates are higher in the suburbs.
The Methodology and the Results
Our study of the nation’s top 50 metros defined “good suburbs” as submarkets outside a central business district that shared two characteristics: They’re located within economically healthier metro areas (those with net employment growth of at least 3.0%over the last six years) and have average monthly rents that top their parent metro’s norm. Those two factors alone turned out to be reliable predictors of performance.
“Good suburbs” perform in line with CBDs because they share many of the same characteristics: more jobs, higher incomes, higher home prices, more amenities and proximity to major highways or rail stations.
Both “good suburbs” and CBDs inside the same metros notched total returns of 12.5% over the last four years, covering the current up-cycle, according to our analysis of NCREIF data. Over the last eight years, adding in the recession, CBDs outperformed “good suburbs” by a thin margin, 7.9% to 7.6%. On a risk-adjusted basis, though, CBDs lagged behind due to a higher degree of volatility – in both good and bad times.
Investment returns – like rent growth – diminished in other suburban categories. The weakest performances came (not surprisingly) in lower-rent suburbs of economically weaker metros.
One important disclaimer: NCREIF depends on appraised values for capital returns, and appraisals tend to lag behind actual transacted values.
Growing Pool of Pro-Suburbia Research
MPF Research’s studies are supported by a growing pool of research showing that suburbs are not the dead investment category they sometimes have been portrayed to be. The NAIOP, a trade group for commercial real estate developers, published a study of office properties and found similar performances in CBDs and “vibrant” suburbs. The Wall Street Journal posted an article calling “the end of the suburbs” one of the top five American migration myths. Trulia published research showing that population growth is higher in the suburbs than in urban areas.
Implications for Apartment Investors
Apartment income returns in CBDs have recently weakened due to an unprecedented supply wave hitting downtown submarkets. Halfway through the 2010s decade, apartment development in CBDs has totaled nearly 250,000 units. That’s already more than was completed in the entirety of any decade since at least the 1940s, according to data from the Census and MPF Research. The development surge challenges the CBDs’ barriers-to-entry narrative. Developers tell us that they frequently encounter NIMBY-ism and master planning objections in the best suburbs, compared to pro-revitalization (often incentivized by local governments) in many downtowns.
Make no mistake: We aren’t arguing against apartment investment inside CBDs. The long-term returns are impressive and the outlook remains bright – assuming a moderate slowdown in construction. But investors continue to pay a premium for urban addresses – typically with cap rates 50 bps below suburban deals.
Our view is that over the next few years, “good suburbs” will outperform CBDs with better rent growth due to less supply pressure and equally strong demand tailwinds. Long term, if you assume reversion to the mean, the two groups could perform in line with each other but with less volatility in “good suburbs.” The point, then, is that for institutional investors eager to expand investment options without adding risk, these “good suburbs” are worth a deep look.
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