November 15, 2021
By: Hui-Wen Shiau, Managing Partner, Cypress Capital Group
When COVID-19 first ran rampant in early 2020 and caused nationwide shutdowns, people across the globe had to remain indoors in quarantine. As states across the country began to reopen last summer, it was widely reported that there was a mass exodus of residents leaving New York for Florida, and California for Texas. Rather than rely on anecdotal stories, which may not represent the whole, the data tells a different story.
The demographic data refutes the often-hyped story that many are leaving expensive cities for cheaper locales. This de-urbanization trend is neither true over 10,00 years of history nor across geographies. Civilizations have thrived in Rome, London, Beijing and more recently New York City. The Spanish flu pandemic of 1918 killed 50 million people globally, yet cities continued to grow over the past 100 years.
FIGURE 1: Migration Flow Santa Clara & San Mateo Countieshttps://siliconvalleyindicators.org/data/people/talent-flows-diversity/migration-flows/foreign-and-domestic-migration/: Where and What to Invest in CRE Post Pandemic
But let’s look at more recent data for Silicon Valley (“SV”) as represented by Santa Clara and San Mateo counties in Figure 1. The net migration from 1998 to 2020 in SV, some of the most expensive zip codes in the country, is essentially zero. In 2020, the net migration of 10,000 leaving SV out of a population of 3,000,000 is statistically insignificant. While the net migration is inconsequential, the population of SV and moreover, California, is evolving with better educated and higher income earners moving to California as compared to those leaving. The rising costs in cities and its attendant economic consequences are not unique to California but globally; New York City, London and Hong Kong have all continued to thrive. Cities are not hollowed out because they become more expensive. People remain in cities for the increased opportunity to generate income and for the positive benefits such as museums, entertainment and culture. The argument that citizens are moving due to costs alone are incomplete and inaccurate in the aggregate.
FIGURE 2: Country-Level Temporary Moves Normalized
In Figure 2, the flight out of cities to suburban and rural areas during Covid in 2020, have already reverted to normal in 2021. There is no identifiable long-term trend in the United States to move from cities to suburbs.
Economic Rationale for Cities to Outperform
The universal truth toward urbanization is true across time and geographies. Physicist Geoffrey West demonstrates in a wonderful TED talk, “Surprising math of cities,” that we are 15 percent more productive living in cities than not. We are able to network socially and professionally easily when there is a critical mass of talent in a city. We are also greener as we take public transportation.
Amazon was turned away by local politicians when it selected New York City after years of careful analysis as it HQ2 but its rationale for picking New York City remains valid: Cities are where the talent congregates. Amazon did not pick a location because it had the cheapest land or the lowest state income tax rate. In today’s tech economy, driven by the need to solve previously unsolved problems, companies must hire the best engineers and management teams. The old economy was about cost savings because the technology was mature and pricing power was weak. The new economy is winner takes all. Either one owns the technology and dominates, or one loses and becomes obsolete. To this point, the Big-4 tech companies (Amazon, Facebook, Google, Apple) continued to expand their footprint through the pandemic adding 1.6mm SF of office space in 2020.
FIGURE 3: Big-4 Tech Expanding in NY During 2020https://www.nytimes.com/2020/10/13/nyregion/big-tech-nyc-office-space.html: Where and What to Invest in CRE Post Pandemic
Whether cities are politically hospitable or not, tech companies must go to super cities such as San Francisco and New York City because that is where the talent resides. However, there are limits to the anti-business rhetoric of politicians in creating the culture of collaboration necessary between public and private enterprise to compete in our global economy.
Technology Trends Favor Super Cities
If we believe that technology companies have been the economic engine for driving the S&P500 higher and the creator of unprecedented wealth over the past 20 years (and of course since the dawn of civilization), where are the pockets of venture capital investing? VC investment in the San Francisco Bay Area and New York has grown from 30 percent market share of entire United States to 50 percent from 1995 to 2020. See Figure 4. Moreover, of the six tech-centered cities in Figure 5, the combined San Francisco, New York City, and LA dominate with 91 percent market share as of 2020; in comparison, Austin is ranked sixth in venture or approximately two percent of the top six cities in the United States. Other cities may get all the oxygen in the room and they may be growing but they are a very small market in comparison to New York City or a San Francisco.
FIGURE 4: Venture Capital Investment
FIGURE 5: Venture Capital Across Cities
Post Covid-19, What Commercial Real Estate is Favored?
The historical data in Figure 6, while a bit dated, is of a sufficiently long time frame (25 years) to capture many economic cycles and may be representative.
FIGURE 6: Multifamily had the highest Sharpe ratio across all CRE over 25 years
If the historical returns favored multifamily over other CRE, the future is even brighter in a hybrid work model. Tech investment returns and tech culture have hyper-dominated the economy and way of life in the past decade. Silicon Valley, not Wall Street, has led the change in removing the suit-and-tie uniform of the past century; going green via net zero emissions; increased social consciousness, as reflected by the Business Roundtable new philosophy that “companies should serve not only their shareholders, but also deliver value to their customers, invest in employees, deal fairly with suppliers and support the communities in which they operate.” With regards to the hybrid-work model which has been forcibly adopted globally during Covid, tech companies have been using a more generous hybrid work model well before 2020.
Moreover, we and other techies were using Zoom many years before it became a verb in 2020. There are many companies with its “war on talent” which adopted hiring engineers everywhere. Tech companies have performed well with established hybrid work models.
There is no question that the hybrid work model is here permanently as it’s a win-win for employers and employees. On the margin, the implications are that residential properties, both single family and multi family, have greater relative importance than in the past and offices will have less.
The rise of Amazon and online retail created headwinds for retail properties, and we see the hybrid work model having the same deleterious impact on office space. It will take years before equilibrium is reached but, in the meantime, residential properties will have significant tailwinds.
At Cypress Capital Group, given the above data and well before Covid, we have only invested in residential properties in tech-centered cities over the past decade. There are many other positive attributes of residential properties beyond the Covid impact such as shorter exits. It takes two years for single family development versus 10 years for an office/retail complex. There is absolutely no visibility in projecting a 10-year investment horizon for office. In addition, residential properties, as Buffett has said, are a productive asset. If we are caught in an economic downturn, there will always be renters in tier 1 tech-centered cities, generating positive yield. This is not true for offices in a downturn; there are only empty offices. We still have to live somewhere. This sticky business model is what allows steady increases in residential rental yield over time.
Over the past 70 years in Silicon Valley, there has been a seven percent annual appreciation in home prices and with a two percent cap rate – that is an unlevered nine percent return by doing nothing. Cypress Capital Group has achieved a 20-30 percent net IRR in normal times over the past decade and two percent return in 2020 during the worst pandemic of the last 100 years. Today, in New York City, after a 30-40 percent decline in residential properties since 2015, we are bullish over the next three years.