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Are Conditions Ripe to Spur Real Estate Investment in Gateway Markets?

In uncertain economic environments, institutional and foreign commercial real estate investors often revert to the safety of the biggest American cities.

Only a few years after many observers were declaring that New York City, San Francisco and other gateway U.S. cities have forever lost their appeal to commercial real estate investors, new sentiment surveys are showing gateway markets are coming back in favor.

The most recent example is the global sentiment survey by AFIRE (Association for International Real Estate Investors), which included 100 members globally and indicated a resurgence of interest in gateway cities by institutional and cross-border investors in United States. According to AFIRE polling, 45 percent of its survey respondents are planning capital allocations in real estate assets in New York City; 22 percent are planning allocations to Boston; and 14 percent are planning allocations to assets in Washington, D.C.

Similarly, when capital services provider Berkadia conducted its January 2023 Powerhouse Poll Outlook, it found many of its brokers expect investors to have a renewed focus on class-A and class-B properties in gateway markets like New York City.

According to data provider MSCI Real Assets, any increase in investment sales in gateway markets over sales of properties in secondary markets has not yet been evident in transaction data. The difference in transaction volumes between major and non-major markets in the fourth quarter of 2022 was negligible, according to the firm’s researchers. Sales of properties in the top six gateway U.S. markets in the fourth quarter of last year totaled $40.6 billion—down 61% year-over-year—while sales of properties in non-major markets were down 63% year-over-year, at $98.3 billion.

The Manhattan commercial real market did show some signs of a rebound in 2022—year-over-year sales rose by 8%, to more than $21 billion, to a large extent driven by office transactions in the first half of the year. And while the increase was small, it stood in stark contrast to double-digit declines in many popular secondary markets.

And when it came to acquisitions by cross-border investors specifically, Seattle, Manhattan, Chicago and Los Angeles continued to make the top markets for their capital inflows in 2022, though all of them saw declines in year-over-year investment volumes (the same was true for top secondary markets such as Dallas and Atlanta).

“New York’s return to the number one spot in AFIRE’s survey is a return to normalcy,” said Aaron Jodka, director of research for U.S. capital markets, with commercial real estate services firm Colliers.

In fact, the focus by institutional and foreign investors on gateway cities should not come as a surprise, according to William Shanahan, chairmen, New York City capital markets, with commercial real estate services firm CBRE.

“Many investors made money after the GFC concentrating on assets in gateway cities. Where we do see interest, limited as it is, is in higher-quality assets that are either newly constructed or substantially renovated, but those owners do not want to sell,” he said.

Investor interest in San Francisco office assets is also returning, according to Jodka, with pending trades, if they end up transacted, offering intriguing cost on a per sq. ft. basis. He suggests that these potential transactions could provide a clearing of assets and flood of value-add and opportunistic capital investment.

Foreign investors continue to feel most comfortable investing in gateway cities, including New York, Los Angeles, San Francisco, Chicago and Washington, D.C., because they have visited these cities and are more familiar with them than with secondary markets, said Chad Littell, national director of U.S. capital markets with real estate data firm Costar. “The globally strong dollar will limit incoming capital from foreign sources for now,” he noted. “As we see global growth again, the first places foreign investors will go are primary markets.”

In addition, gateway markets offer higher barriers to entry for new development and often better liquidity, according to Jodka. Relative to smaller cities, gateway markets require a lower return threshold, but foreign investors tend to have long investment horizons and use lower leverage, which allows them to look past market dislocations for long-term value, he noted.

As far as what types of properties are likely to get the most attention from investors in gateway markets, Littell noted that those looking for industrial product are currently looking for assets in low-risk, high-barrier to entry markets near large ports, such as Los Angeles. That’s because there is less chance of competing with new construction.

In fact, quarter-to-date in the first three months of 2023, New York City has already seen $1 billion invested in industrial assets in New York City, according to Littell. The long-term quarterly average for industrial transactions has been $940 million, he added.

In addition, New York City multifamily assets continue to create strong interest among investors, Littell said. While there was a drop in investment sales volume in the sector in the fourth quarter compared to the year prior, the $2.65 billion in New York City multifamily sales was in line with the city’s long-term quarterly average of $2.6 billion.

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