It’s football season which means sports sections of every newspaper is talking about the favorite in different football games. The one that has me thinking about this at the moment though is Arizona vs. UCLA where Arizona is apparently a 6.5 point underdog. This reminded me that this doesn’t mean that handicappers think that UCLA is a better team by nearly a touchdown. It simply means that betting dollars break even between the teams at this line.
The same is true of CRE. Rental rates are not a sign of which buildings are better or worse. Rents don’t necessarily reflect a more desirable labor market. Rents don’t necessarily reflect “hot” markets even. Rents are simply a reflection of where the money is flowing. Money often flows in waves together. Groupthink sets in and suddenly everyone moves the same direction almost “just because.”
The “best” or “hottest” real estate market may not be the one with rents going up fastest or highest. Those metrics only reflect demand (which is often but not always correlated to quality) which can be just as easily be manipulated by marketing or a good story.
Rent does not correlate to “where the money is flowing” or “groupthink/just because”. Rent equals the sum of operating costs, taxes, debt service and, in a capitalist/market economy, profit. In any given market, the profit portion of rent is driven by scarcity (an insufficient quantity of resources, goods, or abilities to achieve the desired ends) and efficiency (which is the relationship between ends and means). If three substantially equivalent spaces are available, and one is priced lower than another, then the lower priced space will rent first. (All the time, every time). Rents “act rationally”, with a high level of predictability. That said, real estate markets are inefficient. A higher priced space will lease first if a tenant isn’t aware of the market or is heavily influenced by other criteria impacting the comparison between what others would deem “equals”. (Which is driven by both tenant perspectives and marketing differentiation). The profit portion of rent increases when demand is high and/or the supply is constrained (i.e., more tenants are looking for fewer spaces), which is much more than “just because”.
Thanks for the comment Ken! Great feedback but I think you missed the point I was making. I wasn’t trying to imply a “just because” mentality to rents because I completely agree that rents are demand driven in general (as you say, rents act rationally and therefore rise in the face of high demand and drop in the face of low demand).
My point was that given two markets 15 miles apart (different enough labor pools and real estate markets as to be distinct) companies tend to flock together and locate near where everyone else does. Some markets receive more or less demand for space simply because that happens to be where companies choose more often. Given two equivalent buildings within any given 2 mile radius and of course a business will choose the lower cost location (even though there are plenty of rational reasons a tenant would choose a higher cost location for reasons such as Green/Sustainability, better marketing, signage rights, etc.)
In Atlanta (for example) the market tends to go toward Midtown or Buckhead or Perimeter with some regularity with each developing its own market identity. But there are interesting submarkets with the same labor dynamics (if not better) for certain businesses yet are often overlooked (for example Alpharetta, North Cobb, Decatur) often only because others aren’t moving there (the “safe choice” concept).