April 29, 2019
Interviewed by: David Snow
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RE Deals in Thriving Cities With Lower Costs of Living

With real estate valuations through the roof in big US “gateway” cities like New York and San Francisco, many institutional real estate investors are looking for opportunities in the “rising” or best secondary cities like Minneapolis and Nashville. Hear a conversation among three real estate investment veterans active in these cities and excited to be deploying capital where cap rates are higher and the cost of living is lower.

With real estate valuations through the roof in big US “gateway” cities like New York and San Francisco, many institutional real estate investors are looking for opportunities in the “rising” or best secondary cities like Minneapolis and Nashville. Hear a conversation among three real estate investment veterans active in these cities and excited to be deploying capital where cap rates are higher and the cost of living is lower.

RE Deals in Thriving Cities With Lower Costs of Living

David Snow, Privcap:
Today we’re joined by Laura Dietzel of RSM, Derrick McGavic of Newport Capital Partners, and Preston Sargent of Bailard. Welcome everyone to Privcap today. Thanks for being here.

Unison: Thank you.

Snow: We’re talking about a very hot topic: Rising cities in the US. These are places that are generating jobs. They’re not gateway cities, but they are drawing young people who are looking for opportunities, and often with a lower cost of living. They’re also a great opportunity for real estate investors, institutional real estate investors like the three of you, and so I’m fascinated to hear your take on what makes for an attractive opportunity in these exciting cities today.

Maybe starting with a question for Preston, first. Talk about what we mean when we say rising cities. Different people pick different places. Why do you pick the secondary cities that you are active in and what are the common characteristics of these places?

Preston Sargent, Bailard:
Well, the primary reason that we’re focused on some of these cities that you’ve called the rising cities, we call them strong secondaries, other people call them sort of first class, next tier cities, they have a lot of different monikers attached to them. But they’re cities that are the non-gateways, and the gateways are the traditional coastal cities: Boston, New York, Washington DC, Seattle, San Francisco, LA, and then Chicago.

And frankly for us, those cities have just gotten too expensive. There’s been too much money chasing too few attractive real estate opportunities, and for us it’s a matter of trying to find good relative value in some of these second tier or secondary cities.

Sargent: And the characteristics that I think are fairly common are good job growth, good population growth, a large percentage of college graduates, and like the gateway cities, they’re magnets for smart, talented, energetic, creative workers and employees, and so they attract employers that want to tap into that pool. And so, cities like Dallas and Charlotte and Raleigh Durham and Salt Lake City, and Phoenix and Houston, and Minneapolis, are very attractive, and they trade for us as an investor at a substantial discount to those gateway cities that I listed at the outset.

Snow: Derrick, talk about what attracts you to a certain destination and what the characteristics are.

Derrick McGavic, Newport Capital Partners:
Well, first of all, to phrase it a little bit, Newport is a neighborhood retail community, shopping center investor, so by definition, we’re all about the neighborhoods, and to echo onto what Preston was saying, our focus is—we don’t have a moniker for rising cities, they’re just cities. We’re really focused about neighborhoods that are near Fortune 1000 company headquarters, have a good university system nearby, as well as healthcare and some proximity to a technological hub, even a small, growing one.

Snow: Laura, your work with institutional real estate investors has taken you many places. Talk about some of these exciting rising cities that you’re doing work in, and what are the characteristics of these places that people get excited about?

Laura Dietzel, RSM:
So, certainly we’re seeing, in terms of macroeconomic trends, a really great urban and rural divide, so those economies that are most closely tied to the new economy that’s anchored to technology, life sciences, healthcare, media, are bustling. Those that are anchored to the old economy: manufacturing, and agriculture, are struggling. So, to echo the sentiment here, it’s really following where the capital’s going.

So, technology anchored cities are definitely attractive. Austin, Nashville has come out as an epicenter of healthcare technology, which has been really attractive. Those cities also have a great talent pool, anchor to universities, and great institutions, as well as state government capitals, which have just natural recession-proof characteristics, because there’s a set employment and large employer there, that’s not going away.

Snow: Can the three of you talk about cities that you have recently been active in, whether it’s investing or working with clients? Talk about why you went there and give a brief overview of the project that you were working on.

Sargent: I think one of the cities that we’ve had a fair bit of success in in the last few years is Minneapolis, and we went there for many of the reasons that Laura just described. It’s got a great base of employees. It’s got a large university—the University of Minnesota is right there in Minneapolis St. Paul—and a number of Fortune 500 companies.

It’s got, obviously, huge healthcare, which is a driver, and it’s becoming a little bit of a tech hub. It actually has a number of Amazon employees, and might grow as a result of the recent decision by Amazon to not come to New York. And we’ve invested in an office property there, and built two apartment properties and a retail center, and it’s been a wonderful successful story for us, and all the drivers are there.

Snow: What kinds of tenants do you think you’re going to be able to attract, and how did you get comfortable with the way that you underwrote that deal in particular?

Sargent: So, the building we bought is in the suburbs, it’s in the southwestern suburbs of Minneapolis. We bought it. It was 80% leased, and what we did with the building is we went in and tore out the lobby and fixed that up, we fixed up the deli and on the first floor, we brought in a brand-new health club in the basement level. So we did all those things and the property is now 96% leased, and frankly we have more demand from tenants than we have space at this point, from the existing tenant base.

McGavic: We recently acquired an asset that Bailard had actually owned from, I think, 1991 through 2006, called Brownstones.

So, it’s Milwaukee, which everybody is going to say “Oh, what a dirty little town.” But Milwaukee has four Fortune 1000 company headquarters, it has one of the largest Children’s Hospitals in the Midwest, about 10 miles from us, there’s an Amazon fulfillment center employing 600 people four miles away, and what’s fascinating about this is it’s Kroger-anchored, so you have an investment-grade grocer. They’re working very diligently on their pickup, click, and delivery method, TJ Maxx, and the actual roster you’d anticipate of any neighborhood grocery center.

If you took that same asset and put it east of I-5 in Los Angeles County, with a lower grade anchor, with lower grade secondary shops, it would trade for about 150 to 175 basis points lower of going in cap right, at least.

So you have more ability to push rents and revenues in a secondary city than you do in a primary city, and we think, on a risk adjusted basis, we’ll make more money.

Snow: Is part of the way that you underwrote that particular mall investment predicated on the growth of either Milwaukee’s economy or Milwaukee’s population?

McGavic: The nice thing about being a neighborhood community retail investor is you’re not anticipating growth. What you’re really anticipating is that things are not going to shrink.

Sargent: the disposable income in those wonderful, traditional old suburbs, is significantly higher than it is in some of the fancier cities that we’ve already talked about.

It’s because the housing cost in Milwaukee, and in suburban Chicago, and Columbus, and Cleveland, the housing costs are actually really reasonable, so people may make a little bit less money than they do in some of the fancier tech markets, but they’ve got a lot more in their pocket at the end of the day because they’re not spending 40, 50, 60% on their housing costs.

Dietzel: It’s going to be consumerism that’s really driving growth, and so if you’re looking at it from that angle, cost of living is huge, and that’s why we’re really seeing an influx to these cities that are more affordable, especially for millennials who are priced out of those really extremely pricey coastal markets.

Snow: Laura, as you’ve discussed, you’ve been to all these rising cities and you’ve done a lot of work there for a variety of institutional real estate clients. Talk about a really interesting project you’ve done recently in one of these cities and why you were there, and sort of what the thesis was.

Dietzel: A hot-button issue in real estate currently are opportunity zones. So, everybody’s trying to find a way to get into an opportunity zone and investors are doubling down in areas they already were strongly favoring ahead of the legislation that came out through the Tax Cuts and Jobs Act.

So, an area that’s been really exciting has been Nashville. There’s an opportunity zone and a really attractive track where we’re seeing some activity and investments that were already made, and just a doubling down and a really more efficient tax strategy for investors to go in on. Again, anchored by a strong migration base, so a lot of millennials are favoring Nashville as a lower cost city, a city where they can live, work and play, which is something that’s really high on their priority list vs a city where it’s just work work work, potentially on the coast. They’re really looking for a more balanced lifestyle, and Nashville really affords that, being known as a music town, and having that attractiveness to it, as well as affordability.

We’re also seeing that Fortune 500, 1000 companies are moving a lot of back office operations into cities like Nashville, where the relative cost of doing business is much lower. So they can have their corporate finance and accounting teams housed out of Nashville, but maintain their headquarters on the coasts.

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