California, with a gross domestic product of $2.5 trillion, has the world’s sixth-largest economy, ranking just behind the United Kingdom and ahead of France and India. In addition, the state economy grew by 3.2 percent in 2016, according to the California Legislative Analyst’s Office, more than twice the national figure of 1.5 percent and higher than the growth rate of any other state.
For those who invest in real estate in the Golden State, it makes sense to ask where the greatest need for investment lies. The most pressing need is arguably for additional housing close to jobs, which therefore represents the most interesting opportunity for investors. While there has been speculation that certain segments may been overbuilt in certain submarkets, the need for small-scale development in the most desirable neighborhoods should be more appealing than ever. A recent New York Times article explores what the writer describes as a “full-scale housing crisis” gripping the state, featuring a lack of supply, local opposition to many developments, plummeting affordability, and even proposed state laws to restrict local residents and cities from stopping developments that conform to existing zoning.
The Contenders/Other Opportunities
This discussion examines four sectors of commercial real estate—apartments, retail, industrial, and office, plus traditional for-sale housing and specialty products like hotels and assisted-living facilities.
The goal is not to predict future returns by asset class: experts in asset classes can do extremely well with their understanding of the nuanced trends within their area of expertise. Instead, this article looks at the entire state by sector and predicts where growth likely will occur and why.
Retail. Online publication Business Insider, in its ongoing Retail Apocalypse series documenting store closings, noted that the United States has 23.5 square feet (2.2 sq m) of retail space per person, compared with its nearest competitors, Canada with 16.4 square feet (1.5 sq m) and Australia with 11.1 square feet (1.0 sq m), according to the Morningstar Credit Ratings report for October 2016. With the steady growth of online retailing versus bricks-and-mortar retail, it seems clear that this asset class will see little if any net growth. In fact, one trend is the redevelopment of retail properties such as enclosed shopping malls for other uses like office space or mixed-use projects.
Office. As is the case with retail space, it appears that the United States has an abundance of office space. Historically, the country has had 200 to 300 square feet (19 to 28 sq m) of office space per employee, compared with, for instance, Japan with about 140 square feet (13 sq m) and China with much less. “Every client we talk to, they’re using less space per person,” Kenneth McCarthy, chief economist for commercial real estate broker Cushman & Wakefield, told the New York Times. The same article notes that New York City–based online marketing tools company Yodle recently downsized from 137 square feet (12.7 sq m) per employee to 122 square feet (11.3 sq m). The article ends on a positive note, pointing out that though tight quarters for employees sometimes create awkward situations, many find the intimacy of a denser work environment to be fun and, in particular, younger workers do not seem to mind.
Industrial. Industrial buildings are a more specialized asset class. On one hand, e-commerce needs modern distribution buildings, which is driving new construction. On the other hand, urban industrial properties are being redeveloped to accommodate higher and better uses, such as creative offices in El Segundo and Culver City, to cite two southern California examples. While the need for industrial space is probably not declining, it is hard to identify a driver of major growth for this sector.
Special-use properties and traditional for-sale housing. The need for specialty properties such as assisted-living facilities is clearly growing with the aging population. For hotels, the need is more for renovation and redevelopment rather than for new construction. As for for-sale housing, the need clearly exists, but the model has changed. In the past, homes were built at a density of four to six units per acre on whatever vacant land was available. This led to California’s suburban sprawl, as well as highway gridlock, which has remained largely unchanged since the 1970s in spite of substantial subsequent population growth. Traffic, more than any other factor, has made the suburban growth model a dead end for California, whether this product type takes the form of subdivisions of homes or garden-style apartments, both of which require vacant land only available many miles from major job centers.
California’s Greatest Need
With a growing economy and increasing employment, this leaves urban housing—both for sale and rental—as California’s greatest need. Research firm Beacon Economics estimates that between 2005 and 2015, California built only 21.5 new housing units for every 100 new residents. A study by McKinsey Global Institute, “A Tool Kit to Close California’s Housing Gap,” ranks the state 49th in housing units per capita. Rising rents and house prices—together with historically low vacancy rates and inventory of for-sale homes—attest to the supply/demand imbalance.
Unless more housing is delivered near where tomorrow’s jobs will be—largely in California’s coastal metropolitan areas—the state economy cannot grow. Delivery of housing is a critical and urgent priority for the state.
The Environmental Argument for Urban Densification
More housing near jobs will lead to shorter commutes for residents, a change that will have multiple benefits, one of which is reduced carbon emissions. A recent study from the University of California, Berkeley, titled “Right Type, Right Place,” estimates that compared with typical suburban growth, an urban growth scenario will eliminate 1.8 million metric tons per year of carbon emissions, equivalent to removing 378,000 cars from the road. The study concludes that focusing on urban redevelopment with smaller lot sizes and multiunit buildings can play a crucial role in efforts to meet state-mandated greenhouse gas emissions goals by 2030.
Large versus Smaller Projects
One challenge for developing housing in California’s major cities is the lack of large land parcels for development. Developers typically must pay a large premium for parcels of one acre or more or hope to assemble such parcels by purchasing multiple lots, which is difficult. It is easier and more cost-effective to acquire smaller lots or two adjacent lots to create projects of about a quarter acre or less. These smaller projects, which often consist of ten to 20 units, will play an important role in addressing California’s housing shortage.
Challenges of Small Urban Residential Development
The path forward for California’s housing development is not simple. Housing affordability in the state by some measures is the worst in the country, and even the addition of many new units is unlikely to bring prices down much. Policy makers and industry professionals should examine the following obstacles and issues as they seek solutions.
- Financing. Construction financing remains somewhat difficult to obtain. Banks are more likely to finance apartment rental projects and less likely to finance condominiums and small-lot subdivisions of for-sale housing. Yet both are needed. Trouble obtaining financing is a particular problem for developers who lack a large balance sheet—the very people most likely to work on the smaller projects needed.
- Parking. Parking requirements have not kept up with the times. With more mass transit available in California every year and the advent of Uber and other ride-sharing services, the number of cars needed per person is falling. For comparison, consider the low car ownership rate in New York City versus that in Los Angeles. When driverless cars become mainstream, the price of ride-sharing services will fall dramatically because most of the expense of the Uber and Lyft services is represented by the driver. If Lyft becomes very inexpensive, fewer people will want to buy a car. And yet in most cities—including Los Angeles—parking requirements have not changed. Already, developers of new buildings are reporting that their garages are never full.
- Neighborhood opposition. Many public leaders agree with the need for more density, for all the reasons cited here, but when constituents complain, they often withhold support for dense projects in their own districts. NIMBY (not in my back yard) groups use many techniques to try to slow or block projects in their neighborhoods. One increasingly popular strategy in Los Angeles is to argue that buildings to be demolished to make way for a new project are historic and deserve preservation. Even if these techniques ultimately fail, they raise uncertainty for developers and hold back the supply of new units, resulting in even higher rents and home prices.
- Affordability. The single biggest threat to urban housing growth is the politics of affordability. If city councils decide to preserve rent-controlled units at any cost, then those buildings can never be redeveloped. This drives up the cost of living in the smaller number of buildings that can be redeveloped, further increasing costs for any new units developed. This perpetuates a vicious cycle of unaffordability, which protects an entitled class of mostly older people who enjoy rent-controlled units or who purchased their homes years earlier, while younger people cannot afford today’s housing. A similar pattern of younger people suffering as older people vote for protection resulted in Greece’s insolvency several years ago.
In spite of all the challenges, urban residential and mixed-use development remains a vibrant part of the real estate landscape. It both addresses one of California’s most pressing needs and offers attractive opportunities for investors.
Jan B. Brzeski is managing director and chief investment officer at Arixa Capital Advisors, based in Los Angeles.