Does the pandemic
opportunity for CRE?
Could COVID-19 balance the scales between markets?
>> Quick takes:
A more balanced economic geography?
- Rebalancing the economy geographically could create widespread opportunities for CRE
- Demand and supply across various property types could benefit
- Growth between metros is not a zero-sum game
- High-productivity metros could benefit from faster population growth
- High-growth metros could grow even faster with a boost to productivity growth
The pandemic clearly crushed economic growth in the first half of the year, with the largest peak-to-trough contraction in GDP since 1945. Even as we expect the economy to begin to recover this quarter, the pandemic should still weigh on growth. How long will that impact last? The easy answer is at least until there is a vaccine, but likely longer than that as hysteresis could produce medium-term damage. But beyond that juncture what about long-term impacts? How should we think about the transition from short-term to long-term and the influence of the pandemic on the geographic distribution of the economy with meaningful implications for commercial real estate (CRE)?
Extensive Growth versus Intensive Growth
Using New York as an example, such changes could spur more widespread development of residential, redevelopment of older, inefficient office buildings, and more defensive retail to cater to a larger population.
Fundamentally, economic growth concerns production – that is, that amount that can be produced (not purchased), and thus the term gross domestic product (GDP). Production involves turning inputs into outputs. The economy uses three broad inputs: labor, capital, and natural resources. Extensive growth refers to GDP growth caused by increases in the amount of inputs to production. Intensive growth refers to GDP growth caused by more efficient use of inputs (i.e. increased productivity). Therefore, to grow the economy we can either obtain more inputs to production or we can use them more efficiently. While all three inputs prove important, here we focus on the one most directly vital to CRE, labor. What does the pandemic hold in store for labor and what will that mean for CRE?
Let’s handle the intensive side first with labor productivity. Labor productivity can most easily be defined as the output per worker per hour. Labor productivity in the U.S. held steady in the decades following World War 2. Then started declining in the 1970s and 1980s. From the mid-1990s through the mid-2000s productivity growth surged, largely due to the widespread adoption of personal computers coupled with the advent of the information age. But by the latter half of the 2000s, that boom ran its course and productivity growth resumed its downward trend. Though some have wondered if we are miscalculating productivity growth, numerous studies have demonstrated that is not occurring. Accelerating or even maintaining the rate of productivity growth becomes increasingly difficult as workers become more productive. How? The textbook answer says that productivity grows via increases in human capital (e.g. education and skills), investments in technology to help workers, etc. No magic formula exists. Meaningful gains in productivity often arise from paradigm shifts like the widespread adoption of computers, not marginal changes like slightly better smartphones.
But within that, the U.S. does not have uniform productivity or productivity growth by geography. Broadly, productivity growth is higher in larger metropolitan areas, especially key ones that are vital to the current structure of the economy such as San Jose, San Francisco, and New York. Workers are more productive in these regions for all of the classic urban economics arguments, but fundamentally well-established research shows that large metropolitan areas achieve higher productivity through education/learning, knowledge/information sharing, and specialization that derives from agglomeration.
Declining labor productivity growth
Labor force growth
The labor force in the U.S. continues to grow as the population grows, but the growth of both is slowing over time. The birth rate in the U.S. has been declining over time and has now fallen below the replacement rate, effectively the replacement of parents by their children. When the birth rate falls below this rate population growth will slow. The other main driver, immigration, also slowed on an absolute and relative basis from a surge during the early 1990s. Like productivity growth, population growth differs across geographies. The metro areas with the fastest population growth tend to locate in the Southeast and Southwest such as Austin, Charlotte, and Orlando.
Clearly, the metros that dominate these groups are taking opposite paths to growth. Large, key metros are using productivity growth to drive their economies forward. Their size and often limited supply of land and housing inventory (some of which is self-inflicted), and high cost of living (especially housing due to limited inventory) restricts population and labor force growth. Metros in the Southeast and Southwest typically have not had the caliber of workforce to generate the highest levels of productivity and productivity growth but instead relied on population growth to drive their economies. Together, they have created an uneven economic landscape that could use more balance. The key metros’ ability to grow remains limited by their size constraints – research shows that with better housing policies these metros would grow faster and increase the economy of the U.S. by nearly $1 trillion. And faster growing metros could benefit from an influx of higher-productivity workers.
What about the pandemic?
That brings us to the pandemic. While we do not know the precise path forward, we can easily envision a future where we have more balance between these metros. If some of the higher productivity workers (or at a minimum the companies hiring these workers) decide to locate or relocate to smaller, faster growing metros they could provide these metros with a boost that can raise their growth rate. Some of this was occurring before the pandemic, but it will likely accelerate this trend. For the larger, key metros, while any outflow of workers, especially high-productivity workers could cause a disruption in the short-run, in the longer-term the benefits of these cities will likely continue to outweigh the costs and companies and workers will continue to locate there. But in between, the opportunity exists for these areas to potentially benefit. If housing costs decrease as some workers leave, that could enable other workers to move in that might otherwise get priced out. And if (and we stress if) these cities realize that during tough times they can spur growth by making housing development easier (and ultimately cheaper) that could become reinforcing. Ultimately, that could produce a more balanced economy with key cities remaining highly productive, but with a faster growing population and with faster growing cities benefitting from an influx of higher-productivity workers. Although that sounds like a zero-sum game, one must remember that population growth remains positive, even if slowing, providing more workers for both types of metros. And, of course, boosting population growth would provide even more workers and faster growth in the long run. For a glimpse of this future, look to technology companies. They continue to grow their presence in key metros such as New York while continuing to expand into the faster-growing metros such as Austin and Nashville.
Implications for CRE
For CRE this potential future creates tremendous opportunity, even if the short-term presents challenges. As faster-growing metros capture more higher-productivity workers, demand for all types of CRE will increase, especially ones that serve these workers such as high-end office, discretionary retail, industrial, and high-end housing. For the key metros, faster population growth would beget not just more demand for virtually all property types, but increased development or redevelopment. Using New York as an example, such changes could spur more widespread development of residential, redevelopment of older, inefficient office buildings, and more defensive retail to cater to a larger population. While we struggle to find silver linings from the pandemic, this reallocation and greater balance could prove to be one.
| Thought of the week |
The U.S. remains the second-largest exporting nation in the world, with exports totaling roughly $2.5 trillion in 2019.