By: R. Mark Taylor Mark Taylor spoke at NAREIM‚Äôs 2013 Fall Executive Officers Meeting, where he introduced the thesis expanded on here. He persuasively argues that the sophisticated strategic investor can execute an Urban Regeneration strategy to achieve strong returns, fast realizations, and easy exits; all to achieve superior Alpha returns.    

 “Dull, inert cities, it is true, do contain the seeds of their own destruction and little else.  But lively, diverse, intense cities contain the seeds of their own regeneration, with energy enough to carry over for problems and needs outside themselves.” 

Jane Jacobs, The Death and Life of Great American Cities

¬† For the first time in more than 100 years the urban population growth rate in the United States is outpacing the suburban growth rate. Suburban sprawl from the 1960s has given way to a sustained ‚ÄúBack to the City Movement‚Äù, a return to the urban core sparked and driven by the immigration of those disenfranchised with their sub-urban options and the creative class. A robust, sustained demand for the city experience has been going on for well over ten years in most major metropolitan areas in the country‚Äîa demand that is here to stay. The Back to the City Movement has prospered because it answers a customer demand from the ‚Äúcreative class‚Äù in search of a supply of interesting places to live and work. This has created compelling investment opportunities. Sprawl effectively transformed the integrated, walkable experience of the urban core into bifurcated, sub-urban single purpose uses. The resultant autonomous, automobile- dependent office parks, shopping centers, apartment communities, and for sale subdivisions offered customers a value but sacrificed a lot in exchange. The sub-urban lifestyle was abhorrent to the creative class which was effectively orphaned by the resultant sprawl as the options they offered for housing, energizing work environments, and gathering places, embodying engaging architectural style and walkable connectivity were either non-existent or uninspired. This ‚Äúcreative class‚Äù umbrella includes the ‚ÄúMillennials‚Äù and/or ‚ÄúGen Y‚Äù demographic, the artists, intellectuals, thought leaders, alternate lifestyle community, and other strong and curious spirits who share a love and appreciation of the kind of authenticity, energy, and uniqueness that the cookie-cutter sub-urban landscape rarely delivers. This customer base found the sub-urban landscape boring and longed for a setting that would re-imagine this soulless sameness, and inspire and authenticate their lifestyle and personal brand. The transformation, revitalization, and rebirth of the urban core responds to this pent up, ever growing demand. Unique concepts and ideas, oftentimes emerging from the adaptive reuse of obsolete buildings, in authentic, transforming walkable urban neighborhoods, offer a compelling proposition to the jaded creative class denizen. One-off, aspirational products and experiences, created by artisans with a passion for their craft are offering this customer an opportunity for excitement ‚Äì to not have to settle for boring. Examples include craft beer brewpubs, chef-driven restaurants, loft-style residences, boutique hotels, and inspired office environments. Even when the old mainstays, the Pottery Barns, Gaps, and Cheesecake Factories of the world, are brought into the urban core they see their sales soar compared to their sub-urban locations. This is in part because of the population density offered in the urban setting but also because the vendors have risen to the challenge of creating a more interesting experience than they were typically delivering outside of the urban core. And the customers are responding in droves. But we are only part of the way through this journey of re-imagination. The next chapter in the Back to the City Movement is a significant portion of the younger pioneers‚Äîthe early adapters who embraced the revitalized and reborn lofts and new communities in the revitalized urban core well before many others‚Äîwho have aged and started families. But they have not lost their passion for the city and are rejecting the standard pattern of retreating to the far out sub-urban markets as they start the next chapters in their lives. Instead, they are relocating from higher density, multi-family residential communities in the urban core into the neglected ‚Äúfirst ring‚Äù areas immediately adjacent, the area where the business core historically transitioned to the houses, townhomes, and rental flats of the downtown workforce. Here, they are finding opportunities and values similar to those they found in their first foray into the urban core. These first ring neighborhoods allow them to still experience what they love about the downtown experience but also accommodates the infrastructure they seek for their young families, for example, park space for playing, nearby schools, the pediatrician‚Äôs office, etc. This generation is willing to give up the larger house and yard of the sub-urban experience in favor of the quality of life that the urban setting offers them as well as avoiding the mind-numbing sameness and long commute that sub-urban living usually entails. Most important, they retain something they will rarely find in a sub-urban setting‚Äîa neighborhood with a soul. For the sophisticated real estate investor with an understanding of the ecosystem of the urban core and first ring neighborhoods this presents significant opportunities with exceptional return potential‚Äîall supported by constant demand. To date, the response to this demand has been primarily on a linear, one and done approach‚Äîi.e. early in the transformation of a neighborhood, investments and developments are typically happening sequentially after the success of the immediately preceding activity. This is a result of the type of non-institutional capital usually involved in the early cycles and its accompanying limited scale and narrow impact. Understanding the ecosystem, and the cause and effect of how a neglected urban neighborhood regenerates a strategic investor would create strategic advantage by controlling as much of the emerging market of the neighborhood as possible so as to realize the value he or she helped create. Looking at a transforming-neighborhood holistically as an investment strategy and not on a one off project basis is the thesis‚Äîthe ‚Äúwhat‚Äù‚Äîof Urban Regeneration. Nowhere in this piece will you see any suggestion that this investment strategy is appropriate or recommended because it achieves a ‚Äúdouble bottom line‚Äù, a social good in addition to ROI. Without a doubt, a social good is accomplished through the execution of an Urban Regeneration strategy‚Äîa neglected neighborhood is revitalized; however, this is a byproduct of the business plan, not its purpose. Some investors misconstrue this byproduct as the purpose and that sometimes taints or qualifies their underwriting and the level of capital they are willing to commit. Urban Regeneration is a strategy that responds to the demand of the Back to the City Movement. The key to that strategy is enticing new stakeholders to come into an uninviting area and succeed in stabilizing the neighborhood and planting the seeds for its revitalization. To accomplish this requires a holistic view and understanding of how neighborhoods work.¬† The neighborhood assets that emerge from this process‚Äîthe schools, affordable housing, health care centers‚Äîachieve a social good but also serve to stabilize and transition a neighborhood to the point where both customers and institutional capital will commit to investing; and, by their scale accelerate the transformation of the neglected neighborhood. If the business plan doesn‚Äôt work, the institutional capital will dry up and the social good will stop. Since investment capital is typically agnostic to cause, it should also be agnostic to residual benefit, if that residual benefit negatively influences how the investment is considered. The following thesis shows the sophisticated strategic investor how to recognize high potential, neglected urban neighborhoods and execute an Urban Regeneration strategy to achieve strong returns, fast realizations, and easy exits; to achieve superior Alpha returns. Ready to play real monopoly?  

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PAST

 

“It became necessary to destroy the town to save it.”

In an effort to stem the exodus from our cities in the late 1950s, many municipalities embraced urban renewal‚Äîdestroying what once made up the old neighborhoods in order to create new versions that were hoped to flourish on top of the rubble of the old. This didn‚Äôt work. The failed experiment of urban renewal that started in the 1950s contributed to the deterioration of the vast majority of cities across the U.S. by the 1980s. The results were urban core ‚Äúdead zones‚Äù comprised primarily of tired federal buildings, monolithic office towers filled with professional service firms, regional bank headquarters, dated municipal facilities, government-sponsored special purpose housing, and a vast inventory of substandard, vacant, and dated office buildings. The sea of surface parking typically isolated building from building, human from human. Activity was centered solely around the office user, causing downtowns to become ghost towns on nights and weekends. With the exception of the occasional long time iconic restaurant, what little retail there was only served the office workers. There were typically a few hotels, usually one grand dame from years past, no residential base, and a struggling or vacant flagship department store left over from long ago. This dead zone had no sense of ‚Äúplace‚Äù‚Äîno soul. It‚Äôs a scene that‚Äôs all too familiar. Surrounding this urban core dead zone was a lifeless buffer of neglected, very old housing stock‚Äîthe original downtown serving first ring residential neighborhoods. Rounding out this landscape was typically an ever-growing hospital complex at the edge of downtown and a few out-of-style and way out-of-scale period-specific residential towers that had demolished a cluster of old homes to establish their footprint. The neighborhood infrastructure of schools, recreational centers, libraries, and quality affordable housing had morphed into a state of neglect. As the urban exodus increased in the aftermath of the riots of the late 1960s, the tax and population base declined. Acquisition prices for the properties in these neighborhoods followed suit.¬† As ‚Äúwhite flight‚Äù raced to the sub-urban hinterlands in droves, it produced the phenomenon of sprawl.¬† As the widget builders took us to the heart of darkness with easy and cheap mass-produced sameness, the dead zone at the urban core and the lifeless buffer of the first ring were left to rot.¬†¬†¬†¬†¬†¬†¬†¬†¬†¬†    

Rebirth & Opportunity

Dana Crawford, legendary urban pioneer, with partners on Larimer Street, Denver

In spite of the challenges and setbacks that plagued American cities, the urban setting offered something nothing else could: history, context, authenticity, and ‚Äúplace potential‚Äù. A large percentage of the urban building stock had architectural interest and garnered customer curiosity whenever it was featured in the media. This inspired investment curiosity because you could usually buy it cheap and the coverage demonstrated customer interest. The classic street grid of the city created an embedded proximity for new amenities; people could walk to places of interest. This customer interest, low acquisition pricing and unique potential, generated early pioneering efforts from smaller investors coming back to the city, including homeowners under the ‚Äúgentrification‚Äù umbrella as well as what is known today as the creative class businesses‚Äîthe architects, designers, and free thinkers who embraced the unusual. These brave souls nibbled at the edges of the opportunity, but this one-off approach was slow and piecemeal, and as such required a tremendous amount of small investment to occur to achieve any meaningful impact. And, that wasn‚Äôt happening. But the advocates were not without resolve. Driven by their belief in a future resurgence of their cities, fueled by the hope that there were others who would see the potential, certain there were many like-minded customers who longed for the specialness of the urban experience as they had and would reject the soulless-ness that was most of the sub-urban experience, they took advantage of bargain-basement prices on vacant buildings, and slowly and sporadically started bringing life back to the rotting urban core. Funded by limited local capital‚Äîinstitutional capital wasn‚Äôt interested at the time‚Äîboutique loft and apartment buildings started to emerge and occasionally a small chef-driven restaurant. The customers came, the apartments rented, the lofts sold, and the unique restaurants filled up.¬† The story illustrated that customers were bored with the usual sub-urban fare and embraced the interesting re-imaginings found in the urban core‚Äîreinforcing the resolve of the early investment pioneers. In contrast to the typical impediment to investment and development, where NIBMY-ists are anxious about anything new, this dynamic didn‚Äôt exist at the urban core. In fact, the opposite occurred. Civic leaders were often dying to attract any interest to these neglected areas, proffers were unheard of and public support‚Äîencouragement and capital in the form of grants, tax incentives and tax advantaged debt and equity‚Äîwere readily offered. The smaller local investors were plugged into this dynamic; but, despite the good will and the tools available to help, the 1980s (the start of this trend) saw efforts to revitalize downtowns only limp along. Urban core development garnered quite a bit of interest, but did not approach the state of critical mass necessary to achieve the kind of momentum that would feed on itself. This would all start to change on a fateful Thursday night in the fall of 1994.    

The Friends Phenomenon

On the night of September 22, 1994, NBC, the most popular network on television at the time, introduced a quirky little comedy called Friends. This show spotlighted six white, middle-class, post-college, upwardly-mobile twenty-somethings living and reveling in the downtown urban life experience. From the focus on the local coffee shop, the total silence about cars, and the celebration of the energy and authenticity of living in the city, the show obliterated the perception of downtowns as negative, scary areas. Virtually overnight, the idea of downtown living went from scary and unattractive to cool. The land rush was on in many emerging urban markets and the transformation of tired, neglected neighborhoods started to occur, albeit with caveats. Tired old downtown buildings were reborn as hip residential lofts—creative-class office space and trend-setting boutique hotels started to happen en masse.  Within ten years, urban redevelopment in many urban core areas hit critical mass and started feeding on themselves.  Prior to Friends, curiosity had been raised through the Seinfeld series but that show was uniquely New York City—Friends could have occurred anywhere.  Five years after Friends debuted, Sex and the City made its debut.  While this was also uniquely New York City, it reinforced and glamorized the urban experience. The resultant “halo” effect was tremendous, and continued to spur and reinforce the Back to the City Movement. Despite the growing demand, progress was still funded primarily by local investors, limiting the scale, reach, and velocity of the effort—and in areas where local players were less adventurous or uninterested, downtown redevelopment was often muted or non-existent. This was not from lack of demand; it was simply because institutional capital was still not meaningfully present. There were multiple reasons for this:

• No one fully understood the unfolding dynamic and stability of urban revitalization because it was still new relative to the slow-moving time framework of institutional capital.
• The phenomenon had no track record so there were concerns about exit liquidity and returns. This uncertainty severely hindered any advancement by scale.
• The capital was disjointed. There were various types of investments in play and each typically had its own unique capital source or structure, which made it virtually impossible to approach neighborhood transformation holistically from a scaled, integrated investment basis.

   

PRESENT

Urban Regeneration

      1 + 1 = 3

Holistic Strategy + Capital Plan

= Compelling Returns (Strong Yields)

= Accelerated Realizations (Fast Value)

= Superior Liquidity (Easy Exits)

The dynamics of how neglected urban neighborhoods transform have measureable and manageable variables; and each influences a neighborhood‚Äôs viability and can be accelerated through a holistic, integrated process. It is now not only possible but realistic to strategically spur the transformation of a neglected urban neighborhood. There is historical data showing this to be achievable, and there is investment history to demonstrate the viability of the investment. Urban Regeneration is based on the European model of holistic neighborhood transformation. The process to date has been slow; but it doesn‚Äôt have to be. It is only slow because investment activities have occurred linearly. The big drawback to this approach is that the next deal is always paying for the value created by the last. By implementing a holistic neighborhood transformation plan and corresponding capital plan, informed by a deep understanding of how urban neighborhoods work, Urban Regeneration strategically accelerates the process and mitigates risk. And this strategic approach results in a compelling investment thesis. Forget about chasing Alpha. With this strategy, Alpha is eminently achievable. The question is: do you recognize it, and are you ready to execute at scale to realize it?  

Think Different  

Current investment management practice, with rare exceptions, typically does not approach property-level investment holistically at a neighborhood level. It is usually done from a one off “one and done” project linear mindset. This nuance is critically important. We now know there are cause-and-effect relationships between certain uses and the impact they have on a neighborhood and its ability to transform. The hip coffee shop, for example, that helps define and energize the neighborhood will absolutely affect the neighborhood’s desirability and brand.  But that coffee shop could be the single tenant in a small property and that landlord will want to get the most rent that they can for this user, and that rent might discourage or even drive away that prospective tenant, thus losing the opportunity to begin or cement the trajectory of the neighborhood’s transformation. Getting the most from each individual user makes sense from a traditional investment and development approach—but viewed through the holistic lens of Urban Regeneration, this thinking is medieval and represents an imperfect understanding of how neighborhoods transform. To illustrate this point let’s say the 1,500 s.f. of space the local coffee shop is interested in has a potential market rent of $25/s.f. NNN. And let’s say in order to make the deal happen, the strategic investor leases it to the coffee shop for $10/s.f. plus a percentage override. From a traditional view the investor just gave up $22,500 a year in revenue; which, capped at 7%, means over $300K of value was left on the table.  But let’s say that same investor is putting 500 apartments of 700 square feet each in the same neighborhood and the buzz from that coffee shop can drive a one cent increase in rent and a one unit per month increase in lease-up pace.  If you do the math, the $22,500 given up in coffee shop rent just earned well over $50,000 in revenue.  And putting a 6% cap rate on that increased revenue for the apartments results in a more than 3,000% return on that $15/s.f. coffee shop rent reduction. These are conservative estimates of the impact that coffee shop will have on apartment rentals, and these numbers don’t take into account the percentage rent override that will likely kick in as the neighborhood transforms, nor how that transformation will in turn drive higher market rents for other retail tenants faster than a traditional approach to development.  

Risk Mitigation

Risk mitigation is a key benefit of Urban Regeneration. In a sub-urban setting, the primary barrier to entry is capital. If someone comes up with a good idea and it does well in a sub-urban market, competitors will typically repeat that idea many times over right down the street because of the easy availability of land. This saturates the market and depresses prices. That is not the case in the urban ecosystem where there are significant barriers to the competition’s entry. The primary barrier is that available property is limited, so an investor/developer is effectively buying a franchise due to the finite availability of sites, and that reduces risk. When others are building simultaneously, that competition actually serves to reinforce to prospective customers that the neighborhood is in fact transforming and makes them comfortable in choosing the area to live, work, or open their own business. Second, while the activity being seen in some urban markets to date is strong, it typically represents a small part of the overall metropolitan marketplace. You could do five 250-unit apartment communities and not come close to satisfying the steady demand from the Back to the City Movement. And finding sites to do five 250-unit projects would be a challenge in the urban market where barriers to entry are high and land supply is limited. This contrasts to the sub-urban market where that amount of apartments would represent a small portion of all activity and there would be significant extra land nearby to do more if those were successful—which would be self-defeating.   Investing in urban core opportunities comes with—to paraphrase Warren Buffet—a built-in ”moat” protecting your investment.  

Placemaking

Larimer Square, Denver, CO The adjunct to the ‚Äúwhat‚Äù of Urban Regeneration is the ‚Äúhow‚Äù of Placemaking. At its most basic, Placemaking is the art of creating places where people want to be. All of us have had an experience of being somewhere that just felt right‚Äîinviting, embracing, and comfortable. We enjoyed our time there and didn‚Äôt want to leave. In our man-made world, what creates this reaction is neither random nor accidental. It‚Äôs skillfully crafted by experts whom understand the physiological and psychological wants and preferences that human beings value. It is simple to reference but incredibly hard to execute. The passive component to creating this experience is constructing the built environment: the architecture, design, signage, and other components that create the ‚Äústage.‚Äù In The Social Life of Small Urban Places, William Whyte examines at a granular level why some urban places work better than others; from why the design of the connections between streets and plazas are critically important to why the design and components of successful sidewalks are one of the most misunderstood dynamics in the urban environment, all the way to the psychology of designing the steps in public plazas and open spaces. And in addition to the green spaces, open spaces, walkability, and sidewalks are the lighting, music, signage, and storefront design that fill out the stage. The active component is, in effect, the ‚Äúactors‚Äù that are put on the stage‚Äîthe mix of stores and others businesses, especially the unique, unusual, one-off artisanal shops and restaurant vendors, as well as the events, sidewalk cafes, and pop-up retail offerings. The ubiquitous Pottery Barns, Gaps, and Cheesecake Factories are fine institutions, but are simply ‚Äúmore of the same‚Äù when coupled with other national chains. Yet, when married with artisanal local vendors, they create a much more interesting shopping experience; and that is why chains typically experience greater per-square-foot sales in re-imagined urban settings than in their sub-urban locations. That balance‚Äîthe art and science of what draws and energizes the customer‚Äîis a key ingredient in the successful art of Placemaking. It is also an integral part of the appeal of the urban core  

Place Management

The most important component of the ‚Äúplay‚Äù that is place and Placemaking is Place Management. The ‚Äúdirector‚Äù of this repertory theatre of place is the hands-on interactive oversight of the events and activities that bring a place to life‚Äîthe activities that draw you in, keep you coming back, and establish and reinforce a place as special and important in your life.¬† Great places don‚Äôt come from just building something and letting it exist. The best places come from ongoing place management. It costs money, but the interest and value created by this approach far exceeds the cost to carry it out, and dramatically increases the desirability of the place, everything around it and corresponding values. One of the best examples of this dynamic in the U.S. is Larimer Square in Denver. The design and planning are great, and the details were vigorously fleshed out before it was finalized. From the mix and balance of the artisanal Market bakery and caf√© to the usual suspect of a Capital Grille, the dynamic works. The little unrealized touches like music in all outdoor common area spaces, a rotating seasonal flag/banner program, and the annual over-the-top campy Oktoberfest‚Äîthe proceeds of which pay for the best holiday displays and events in town‚Äîall come together to create one of downtown Denver‚Äôs favorite and most desirable places to be.¬† And of course the rental rates and sales prices for the real estate in and around the area reflect that. ¬†The success that is Larimer Square today began as a holistic plan for a collection of separate, individually-owned, rundown buildings on one block that were originally bought for a song by urban pioneer Dana Crawford and her partners.  

Place Potential

It’s easy to look in the rearview mirror to opine on why a place works. It is dramatically harder to understand the DNA that creates a great place, and harder still to predict if a particular setting has the potential to become a great place. It’s an intricate analysis, but the bottom line is that while the creation of a successful place is a combination of both art and science, the quality of a place is actually measurable and manageable. The variables that contribute to the creation of a great space are defined and can be assessed as to status and potential. These include access, visibility, walkability, draw/lure to the area, design, merchandising plan, and attention paid to the balance between not only the types of uses, but also the uniqueness/artisanal nature of vendors. The disciplined, strategic investor in the urban arena can come to understand these metrics, what to look for, what variables will influence them, and how that all impacts the potential of a place and accompanying investment desirability. Consider walkability as one example. How wide is the sidewalk? What is on each side of it?  What is happening in the built environment that visitors are experiencing as they walk? What are they walking toward and how does it present itself? What are people hearing, smelling? How much shadow is on the street? With regard to access, how easy was it to get to the place, and how visible was it before they got there? What lured visitors there in the first place, and why would they come back? Is it adjacent to a big employment center and is that the connection? Is there some big entertainment center there and is that the draw? Is it known for the best restaurants or clubs in town? Does it have easy access to mass transit? Or, if driving is necessary, is parking easy and affordable or problematic? Every one of these metrics is measurable and contributes to an assessment of a place and it’s potential. This is not the same as Walk Score™. Walk Score focuses on what visitors are proximate to whereas these assessments are focused on the experiential quality of what they’re proximate to. To use an easily understandable metaphor, this is “Moneyball” for neglected urban neighborhood investing. For the strategic investor who understands this ecosystem, the opportunity is enormous because the Back to the City Movement is here to stay and will only grow as the creative class/Millennial/Gen Y population continues to grow as predicted by demographers. As the practice of Placemaking enters the psyche of the marketplace, it will undoubtedly get overused and abused. Just as many urban office complexes of the 1970s vied to come up with the best signature plaza areas (that mostly failed to create the intended vibe), featuring fountains, seating and outsized public art, we will surely see a steady supply of attempts at places in projects that are little more than nice community gathering points that don’t engage the broader neighborhoods and inspire the elusive “There” of a true place. And that “miss” will result in the even greater investment potential that comes with authentic Placemaking.  

The ‘Urban Regeneration Pyramid’

The evolutionary process of transforming neglected urban neighborhoods results from many intermediate steps and activities that incrementally stabilize and start to initiate new growth. The mental