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Monday, September 1, 2014

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Cascade: No. 60, Winter 2005

Developer's Viewpoint: Urban Markets Strengthen, But Standard Real Estate Products Are Not Suited for Mixed-Use Urban Development Communities

Christopher B. Leinberger is a visiting fellow at The Brookings Institution’s Metropolitan Policy Program, professor and director of the University of Michigan’s graduate real estate program, and a founding partner of Arcadia Land Company, which is based in Wayne, Pennsylvania. Arcadia has developments underway in Chester, Berks, and Montgomery counties, Pennsylvania; Albuquerque, New Mexico; and Independence, Missouri. He grew up in Drexel Hill, Pennsylvania, attended Upper Darby High School, and received a bachelor’s degree from Swarthmore College and an MBA from Harvard University.

Leinberger has worked as a consultant, author, teacher, and developer. From 1979 to 2000, he was the managing director and owner of Robert Charles Lesser & Co., the largest independent real estate consulting firm in the country. He consulted on corporate strategic planning for real estate companies, metropolitan development trends, and downtown strategic planning.

He played a leading role in the redevelopment of downtown Albuquerque from 1998 until early 2005 as CEO of the Historic District Improvement Company (an Arcadia-affiliated company), and recently led the process to develop an updated strategic plan for the city’s downtown.

Development during the past 50 years has often followed a pattern of “sprawl” from cities into a succession of more and more distant suburbs. What are the causes of sprawl? What are its consequences?

Understanding sprawl starts with how we as a country have defined the American dream and how we have chosen to invest our wealth as a society. There’s no conspiracy here. Since the Second World War, sprawl is what we wanted as a people.

For 5,500 years of human urban development, the transportation system a society selects has always driven development. We as a society have been subsidizing and building predominantly car-only transportation and development for three generations. We moved out to the metropolitan fringe in ever-lower densities driven by this one-dimensional transportation system, based exclusively on the car and truck. It is important to note that there are only two types of development possible in our country: car-only low-density suburban development and walkable high-density urban development based on a multiple-transportation system. Walking distance historically has been understood to be 1500 feet, or 0.28 of a mile.

About 33 percent to 40 percent of the wealth in this country goes into the metropolitan built environment (land and buildings), according to Bureau of Economic Analysis data. Over the past few decades, we’ve been putting relatively more of our assets and wealth as a people into a depreciating asset, our cars. The typical household in this country invests 20 percent of its household budget in cars, compared with 7 percent in Europe.

One of the most frustrating observations is that our great-grandfathers built beautiful apartment, office, and retail buildings with great architectural design and high-quality construction in the early decades of the 20th century. We rarely build this level of construction quality today in spite of the fact that we’re three times wealthier on a per capita inflation-adjusted basis.

Investments were made in those buildings with a long-term (at least 40 years) perspective. Most times today, we build disposable buildings. We don’t want to invest in our buildings for more than seven to 10 years because we don’t believe that demand for that product will be there longer than that, partly since sprawl continually takes the edge of suburban communities further outward.

Our suburban-oriented development pattern has been based on cheap oil. We’re importing two-thirds of our oil right now. There’s a body of research, controversial at this point in time, that says that this decade will be the peak of worldwide oil production, just as it peaked in the U.S. and Venezuela in 1970, Kuwait in 1974, and the North Sea in 1999, and that world demand may soon exceed the ability of producers to produce. This would mean the end of cheap oil on which we have built our metropolitan areas.

We’ve allowed the infrastructure in our central cities to deteriorate and have been sinking those investments in fringe places that may not have an economic function, or will have a much reduced function, in the future. Infrastructure doesn’t change on a dime. It’s literally and figuratively “sunk” investment.

We must move quickly to invest in a variety of less oil-intensive modes of transportation, such as railroads, light rail, and subways, as well as build walkable places that allow for significantly fewer vehicle trips each day. Smart growth should be our domestic policy and that is possibly the best means to reduce our dependence on foreign oil suppliers. It also helps the environment because the pollution from our car-based transportation system contributes significantly to global climate change. Our development patterns have health consequences, too, because our present reliance on cars, rather than walking, has now been shown by recent research to significantly contribute to obesity.

On a personal note, after I took the position at Brookings this summer, my wife and I looked for and found a residence within five blocks of Brookings, and we happily sold one of our two cars.

Are urban markets changing?

Yes. There’s a very impressive turnaround in most urban and many suburban downtowns. A subjective survey I did of 61 American downtowns found that five times as many are vital or coming back today compared to 20 years ago. This is an unprecedented turnaround.

There are two reasons that urban markets are getting stronger. One is that many of the baby boomers who became empty-nesters starting in the 1990s want to live downtown and not deal with a large single-family house and a lawn. The other is that Gen Xers are more drawn to living in an urban rather than suburban environment; just look at most television programs of the past 15 years aimed at Gen Xers starting with “Seinfeld” and continuing through “Sex in the City,” “Friends,” and “ER.”

Another is that each project in an urban core benefits from an upward spiral of property-value increase. More townhouses, apartments, and retail and office space result in an increase of people on the street and in higher rents and property valuations. In downtown areas, more is better. In suburban areas, more is less; since more development results in more traffic congestion, pollution, and less open space. When suburban development encroaches, the market moves on to the next fringe frontier.

Consumer research studies that my former company (Robert Charles Lesser & Co.) and others have conducted seem to indicate that some 25 percent to 40 percent of metropolitan-area households prefer to live in a community where they can walk to most of the services they require. There is strong demand, but limited supply, for such communities.

It is important to note that most of this market demand to live in an urban environment will be satisfied in suburban town centers, such as Silver Spring and Bethesda in Maryland and Reston, Virginia, since the traditional downtowns have a physical limit to how much supply they can provide. This supply limitation is why many former down-and-out downtowns have become the most expensive places to live and do business in just the last decade.

What are the inherent challenges in building and financing properties in urban areas?

Construction in urban areas costs more — good urban architecture costs upward of 50 percent more than typical suburban buildings. In urban areas, residents and businesses demand a higher quality of building, since you are walking past them, not driving by at 45 miles an hour with the buildings set back 150 feet.

One of the biggest challenges is that there are what I refer to as 19 standard real estate product types that can readily obtain financing and virtually all of them are geared to suburban development. These include grocery-anchored retail centers, walk-up apartments, starter homes, and office parks. Nearly all of these products must be built in a low-density, suburban, sprawling fashion. Yet these are the only products most banks and publicly traded real estate investment trusts (REITs) can build, finance, trade, and own, according to the real estate industry’s new “gatekeepers” on Wall Street.

After the real estate overbuilding bust in the 1980s led to the demise of many S&Ls, banks, and other financial institutions, Wall Street became a major source of real estate finance starting in the early 1990s. Three multi-hundred-billion-dollar types of Wall Street real estate financing are REITs, the commercial mortgage-backed security market, and the residential-mortgage secondary market. Nineteen real estate product types have become the standard as part of Wall Street’s dominance in real estate finance.

Conventional development for income-producing retail, office, and rental properties is based on building according to formulas that provide stand-alone, single uses with access by car. However today, much of the market wants mixed-use projects with retail on the ground floor and housing or office buildings above, but they don’t easily fit any of the 19 standard product types.

In another challenge, for four decades discounted cash flow (DCF) has been the customary way of evaluating the cash flow of income-producing apartment, office, retail, and industrial developments, but this methodology blinds us, since it does not fully value the cash flows in the mid to long term. Suburban projects have a stronger short-term cash flow because they’re less expensive to build and therefore yield higher discounted cash flows. The short-term cash flow of walkable urban projects tends to be not as strong as that of conventional development – but the medium- and long-term returns are significantly better. Wall Street’s focus on short-term cash flow and DCF’s inability to value mid- and long-term cash flow means we have turned this 40-year asset into a seven- to 10-year asset class – hence the cheaper and disposable built environment of the last few generations.

Long-term money is needed to finance walkable urban development, which as I’ve said is more expensive than suburban development. There’s a need for patient equity that could be provided in the future by insurance companies, pension funds, and other long-term investors, but it also comes from land owners, developers who forgo development fees, individuals who have a longer term investment horizon, and municipalities. Long-term investment will make possible constructing buildings with higher construction quality, longevity, and character.

How can gentrification be avoided or minimized as urban values escalate?

You cannot and should not avoid gentrification; it is the market at work. However, one of the lessons learned over the past 15 years as our downtowns have been reviving is that when done right, our downtowns become the highest priced place to live and do business in the metropolitan area. Ten years ago, the suburban office rents in Washington, D.C., were 40 percent above downtown rents; today it is reversed. The most expensive housing in the San Diego, Denver, and Seattle metropolitan areas today on a price-per-square-foot basis is in their downtowns, something that you would not even have guessed would be the case just 10 years ago. As a result, reviving downtowns need to start an affordable housing and commercial space plan early in the redevelopment process. It should not put a burden on the early cash flows of market-rate projects, but there are methods that can be introduced to have the rising values of downtown real estate pay for the affordable-space plan.

What message do you want to share with lenders?
They should be looking at downtown and suburban town centers. The market has shifted and there is pent-up demand for downtown and suburban town center development. Banks should also encourage their developer clients to bring more equity into the deal, including some patient equity. If a deal has increased equity, it will improve a project’s debt-coverage ratio. Banks might then forgo or ease the personal guarantees from the developer as an incentive.

In the Philadelphia area, lenders should also look at development possibilities in older downtowns along the Main Line of Philadelphia, such as Wayne, Bryn Mawr, and Villanova, as well as in West Chester, Swarthmore, and the 69th Street area.

Which are exemplary downtowns that have been or are being revitalized? Why are they exemplary?

Chattanooga, Tennessee, is one of my favorites. The turnaround of this downtown shows what great private and public leadership can do in the face of an average-to-poor economy. Starting with a new vision and a river-focused strategy, Chattanooga now has a downtown entertainment district, an aquarium, expanded visual and performing arts venues, a 10-mile river walk, lots of new housing, new hotels, restaurants and stadiums, and a nonprofit-driven affordable housing effort that produces 500 units a year without displacement. It also has one of the best examples of a nonprofit catalytic development company in the country, River Valley Company.

I’m excited about what’s happening in Philadelphia’s downtown. There’s a large increase in the number of residents who live downtown. I’m also struck that a Center City District survey found that 99 percent of residents of recently completed condominium buildings had college degrees, compared with 25 percent in the metropolitan area, while two-thirds had advanced degrees. These people represent the heart of the so-called “creative class” and a tremendous sign of hope for the future of the city’s economy and tax base.

Other cities that were dead in the water 15 years ago and that today are vibrant communities are Baltimore, Washington, Nashville, Memphis, Oklahoma City, Denver, San Diego, Seattle, Portland, Oregon, and Portland, Maine, and Boise, Idaho. In many of these cities, the most expensive housing in the metropolitan area is now located downtown.

What are your plans for the next year or two?

I want to expand the University of Michigan’s real estate program from a certificate program to a master’s and executive education program. I’m also developing a national downtown assessment system similar to the LEED system for green buildings. I’m also doing downtown strategies for two very distressed cities, and I’m working on a book about downtowns and on a proposed PBS series on the subject.

Leinberger is the author of Turning Around Downtown: Twelve Steps to Revitalization, published by The Brookings Institution in March 2005.

Articles and book chapters that he has written may be seen at www.cleinberger.com. He received the Apgar Award for the best Urban Land article of the year in 1995 and 2003. For information, contact Christopher B. Leinberger at cleinberger@brookings.edu.

Who Lives Downtown?

A recent analysis of downtown population, household, and income trends in 44 cities has found that the number of downtown households increased 8 percent to 13 percent in the 1990s alone.

The analysis, entitled Who Lives Downtown?, was written by Eugenie L. Birch, professor and chairperson in the University of Pennsylvania’s Department of City and Regional Planning and co-director of the Penn Institute for Urban Research. It was published by The Brookings Institution’s Metropolitan Policy Program.

Birch found that the growth in households reflected the proliferation of smaller households of singles, unrelated individuals living together, and childless married couples.

Downtowns, she reported, have a higher percentage of young adults and college-educated residents than the nation’s cities and suburbs and are home to the most and least affluent households in their regions.