Rent valuation: It's about the bang for the buck

Commercial real estate rents are an essential component of the competitive business landscape.

High rents can impede a state's growth but can also exemplify the value of a location. Even when inflated by land constraints, labor costs, materials and regulations, rents can only go as high as tenants are willing to pay.

Hans Nordby, managing director, CoStar Portfolio Strategy
Source: Hans Nordby
Hans Nordby, managing director, CoStar Portfolio Strategy

High-value-added industries, like finance in Manhattan or technology in Silicon Valley, can justify hefty rents. In other words, it isn't simply the rent level that determines business competitiveness, but the bang for the buck.

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Rent levels alone, however, don't tell a complete story. As the relative competitiveness of a state improves, demand for commercial real estate should rise in tandem and affect the rate of rent growth in the short term. In the long term, supply can catch up to demand and dilute its impact on rent.

The graphic shows the weighted-average rent level by state across the office, retail and industrial markets. States at the top have high average rent levels today, while those on the right have recorded the strongest rent growth since the end of 2010 (roughly at the low point of the cycle).

The moderately negative correlation between rent level and rent growth suggests that lower-cost states have been more successful at growing real estate demand, all else equal.

New York tops the rankings with the highest rental rate in the 15 most-populous states, and along with New Jersey, also had the slowest rent growth. This would imply that high rents have undermined competitiveness. But before painting New York state with such a broad brush, consider that New York City—dominated by the borough of Manhattan—is outgaining its intrastate peers with cumulative 6 percent rent growth since 2010, proving that the Big Apple remains quite competitive for business.

The states lumped together in the upper middle of the chart—California, Massachusetts and Washington—have higher-than-average rents, yet are still recording healthy rental rate growth, in part because of their clusters of high-value-added industries, particularly the tech sector. Again,the top-line numbers hide disparity at the market level: San Francisco has notched an incredible 30 percent rent growth since 2010, while some of California's more rural markets have not kept up.

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The third set of states highlighted on the chart offer businesses a different value proposition. Rents in Texas and Arizona are notably lower than rents in the technology states, and as such, make these states compelling lower-cost alternatives as places to do business.

When costs are lower, all else being equal, job growth and the resultant demand for real estate are higher. Yet at the same time, these states' low-cost competitive advantage is being eroded in the short run by a surge in demand.

This threat can be overcome in two ways:The states' economies can evolve to higher-value-added industries in order to justify the higher costs, or development can increase the rentable stock of real estate, easing rent-growth pressures over the long term.

—By Hans G. Nordby, managing director of CoStar Portfolio Strategy