We’ve been exploring a series of Heartland metros that could be appealing to investors interested in workforce housing. So far, Cincinnati, Rochester, and Morgantown shared some common characteristics:
- Affordability
- Economic resilience
- Strong multifamily sectors
- Upside potential
- Built-in downside protection that affords investors a lower risk profile than more traditional coastal markets
Last week, we also shared some macro-level thoughts about analyzing new markets.
This week, we’re diving headfirst into the American comeback story: whether you call it Motown, the Renaissance City, the 313, the Arsenal of Democracy, or the Automotive Capital of the World, you guessed it — it’s Detroit.
Detroit began life as a humble frontier settlement, founded in 1701 by Antoine de la Mothe, sieur de Cadillac ( it’s no Zackquill Morgan, but we still think it's a decent name) as Fort Pontchartrain du Détroit, a river commerce and fur trading outpost. By the late nineteenth century, Detroit had left the fur trade behind. Wealthy shipping and industry magnates brought capital into town and constructed some of the Gilded Age’s most iconic mansions, earning Detroit the moniker “The Paris of the West.”
In the early 20th century, Detroit ascended to the pinnacle of American industry as the world’s largest automotive manufacturing hub, with Ford, Dodge, Packard, and Chrysler anchoring the local economy and propelling explosive expansion. By 1920, Detroit was the nation’s fourth-largest city.
The auto’s industry’s local predominance — which at one point employed over 60% of the city’s workers — was not to last. The mergers and subsequent departure of auto giants, suburbanization, racial tensions, ill-considered housing policy, and substandard infrastructure have all been cited as causes of Detroit’s complex, well-known decline. The bottom line is that industrial reorganization and suburbanization caused mass flight from the urban center until the 1980s. What followed was years of hardship and capital exodus that plagued the city until 2013, when the local government declared bankruptcy.
Today, Detroit is transforming into a more diverse, resilient economy -- especially within the roughly seven-square-mile city center. Automotive manufacturing still employs a significant proportion of the city’s population; Ford and GM are still the two largest individual employers in town, and the manufacturing sector expanded by 3.8% against a national average of 0.9% between 2009 and 2019.. However, Detroit’s largest economic sector is now — you guessed it — “Meds and Eds,” occupying 17% of the city’s nonfarm workforce and including four of the metro area’s ten largest employers. The University of Michigan and Beaumont Health are the two largest players in this corner of the local economy. The convergence of traditional manufacturing, healthcare, education, and a growing service economy bolstered by professional and business services shows that Detroit is transforming and bouncing back.
The city that paved the world’s first mile of concrete and has more registered bowlers than any other U.S. city (you learn something new every day, right?) is entering the 21st century with grit, and offering real estate investors a set of promising opportunities.
Opportunities
How does Detroit’s economy stack up against other metros?
Like our home city of Pittsburgh, Detroit reinvented its economy during the back half of the 20th century in response to industrial reorganization. And, also like Pittsburgh’s, Detroit’s resurgent economy should be more resilient to recessionary pressures and sector-specific economic shocks than the concentrated manufacturing titan of past decades.
While Detroit’s unemployment suffered a significant uptick in response to the emergence of the pandemic, recovery until February 2021 was nearly as dramatic.
Detroit’s recovery lags behind other U.S. metros. However, the swift resurgence indicated by the employment data is a promising indicator that Detroit’s increasingly modern, diverse economy may be better-positioned to withstand economic turmoil than its predecessors.
While the COVID-19 pandemic presented Detroit with a set of hurdles to be overcome, the U.S. Department of Housing and Urban Development doesn’t anticipate that the manufacturing and tech sectors will face enduring setbacks as a result, noting in a November 2020 report that Amazon and Fiat-Chrysler’s planned expansions in the city will create thousands more jobs over the next three years. Amazon wasn’t the first tech firm to move into town either; within the past few years, Microsoft and Google have opened offices in Detroit.
Detroit’s economy is still smaller, from a personnel perspective, than it used to be.
However, GDP growth within the metro area has been strongly positive, partly in response to investment from firms like Amazon, Fiat-Chrysler, Ford, GM, Google, and Microsoft.
Provided economic output continues to increase, Detroit should continue to create jobs and attract workers, improving forward-looking employment prospects in the metro area.
Detroit’s population is smaller than it used to be. But, realistically, real estate investors are more likely to be affected by rental demand than a given metro’s absolute size. Stabilizing out-migration figures and an affordable rental market have elevated rental demand in recent years, and supply has yet to catch up, which could create compelling opportunities for real estate investors.
According to HUD, from 2012 to the current date, net out-migration in the Detroit metro area slowed to 11,500 people annually, which translates to an average annual population decline of 0.4%. According to the Census Bureau in 2019:
- 30.38% of Detroit residents opted to rent
- 28.43% of Michigan residents opted to rent
- 35.89% of U.S. residents opted to rent
Meanwhile, median annual rent as a fraction of median household income in the city was 18.19% in 2019, down from 19.36% a decade earlier and compared to 20.03% nationwide in 2019. In absolute terms, Detroit has historically remained more affordable than the national average, but somewhat less affordable than the rest of Michigan.
Detroit’s single-family market is also very affordable, with a price-to-rent ratio in 2019 of only 5.35. While affordable single-family alternatives can sometimes depress renter demand, this has not been the case in Detroit, where rental unit vacancy rates — one metric for gauging tenant demand — are lower than nationwide and statewide.
More importantly, rental vacancies are now significantly lower than during the peak of Detroit’s economic troubles, suggesting that property owners could be positioned to capture Detroit’s impressive GDP growth through rent increases as demand continues to increase relative to supply. As the job market recovers from the pandemic, and new construction by large, international firms attracts workers to Detroit, these trends could accelerate, creating additional margin for real estate investors to generate returns.
Finally, while the overall rental vacancy rate in the metro area is hovering over 5%, the apartment vacancy rate was closer to 3% during Q3 2020, down only 0.2% from a year earlier despite the ongoing pandemic. If tech and manufacturing jobs continue luring young professionals to the city, apartment vacancy could conceivably tighten further.
For Core and Core Plus funds, Detroit’s in-place demand can offer viable income streams from day one, and the possibility of future economic growth creates room for upside. But, for more aggressive investors, Detroit’s housing market could offer another set of opportunities.
In the popular imagination, Detroit may conjure images of population decreases and urban blight — and to some extent, those impressions are accurate. But, an abundance of underutilized land, vacant lots, and derelict buildings in need of renovation could drive growth and create upside. This is especially true when combined with the demand-side effects of population increases in specific neighborhoods.
While the population of the entire Detroit metro has continued to decline — albeit more slowly than through the last half of the 20th century — Detroit’s downtown and midtown areas have actually witnessed population growth as of November 2020. And, according to the Detroit Regional Chamber, the metro received the second-highest rate of population growth in the 24-35 demographic out of a list of peer cities. Millennials who migrate for job prospects and low living costs and stick around to raise families can turn around an overall population deficit, forecasting future economic expansion in the long term. In the short- and mid-terms, millennials are among the demographics most likely to rent; if Detroit continues to attract more than almost every other U.S. city, multifamily investors could see some upside.
Already, these migration trends have created a hot single-family rental market that local news referred to as “kind of whacky.” This is a recent development, and the demand spike may eventually dwindle; however, if demand in the single-family rental market and the downtown and midtown geographies continues to increase, rents could also rise considerably. Relatedly, a spillover effect can plausibly influence demand for suburban and multifamily properties to increase similarly.
For opportunistic investors, low acquisition costs and rising demand due to relocation from young professionals inclined to rent could be a persuasive combination. If rents continue to increase, especially in hotly-demanded neighborhoods, investors who acquire buildings now — either in cash because Detroit properties (especially those in need of renovation) can be fairly affordable, or by taking advantage of 2021’s favorable rates — could see significant appreciation.
Another approach more aggressive investors may pursue is new construction. According to a HUD report from November 2020, vacancy rates are continuing to fall and rents are continuing to rise, despite recent high levels of new apartment construction in downtown and midtown. This suggests that neighborhood-level population expansion is continuing to outpace the construction of new housing. But, Detroit’s rental market is still more affordable than the national average, which creates a margin for real estate investors to absorb rising demand through rent increases while still retaining an affordability edge compared to other metros — which is a significant consideration for the growing demographic of young, mobile millennials.
Especially compared to similar cities, Detroit’s sprawling abundance of empty lots creates opportunities for opportunistic investors to acquire land cheaply, and develop it into apartments which could see immediate demand — a very different situation than in some of the other metros we’ve explored (such as Morgantown, where mountainous terrain and the density of existing constructions makes development a less likely approach). While that strategy won’t necessarily appeal to more conservative investors, it is an option that more aggressive investors could leverage to produce significant returns.
The comeback is ongoing
The city of Detroit has made significant economic strides since declaring bankruptcy in 2014. The St. Louis Fed estimates a more than 28% increase in GDP over the last ten years — much of which has been attributable to a diverse service economy anchored by educational and healthcare institutions.
However, Detroit’s economic recovery is ongoing, and there’s no guarantee that employment and productivity will continue to rise. A few concerns:
- Detroit’s employment plummeted dramatically at the onset of the pandemic, and while employment has improved since last year, the city has yet to return to pre-pandemic levels.
- Auto manufacturers still employ a large slice of the city’s workforce, and the auto industry could be susceptible to disruption as tech firms impinge on market share, climate concerns decrease demand and increase the costs of regulatory compliance, and an abundance of cheap overseas labor induces employers to offshore. A sector-specific bubble’s impact is diluted in a diversified economy, but Detroit’s auto sector isn’t out of the woods yet.
- Detroit’s poverty rate is decreasing, but at 35%, it’s still 25% higher than the national rate.
- Educational attainment in the city is low, with only 15.3% of the 25-and-over contingent holding a bachelor’s degree or higher. In-migration could positively impact this data point, but homegrown talent will still be important for Detroit’s future prospects.
If economic incentives and an abundance of cheap land can entice more employers into the city, continuing to employ the metro’s growing millennial contingent, rents will probably continue to rise — particularly in highly-demanded regions. But, downtown and midtown are expanding much faster than the suburbs, and real estate investment in Detroit can’t avoid making some long-term bets about the city’s economic health. If that bet turns out to be mistaken, disposition risk could rear its head for overcommitted investors.
Value-add investors may have more opportunity
Cheap empty lots and growing demand, and urban blight ripe for capital-intensive — but potentially lucrative — renovation and rehabilitation investments could position aggressive investors who buy in early to earn outsized returns if Detroit’s comeback continues.
On the other hand, value-add and opportunistic strategies invite more risk. Whether investors opt to construct new housing or undertake intensive renovation projects on derelict buildings, the relative success of Detroit’s comeback over the mid-term will likely determine P&L.
However, opportunities for more conservative investors may decrease if property values increase and new constructions absorb increasing demand, keeping a lid on rent increases. Buying an in-place cash flow is an effective tactic by which real estate investors can insulate against risk, but the popularity of new construction could put a cap on returns for funds only exposed to existing buildings that don’t require capital-intensive renovations.
Is downside protection built-in?
Like we pointed out earlier, Detroit’s economic recovery is only partly complete. On the one hand, that presents investors with an opportunity to make a relatively affordable bet; the city’s concentration of derelict or aging buildings and empty lots lowers investors’ barrier to entry and dilutes risk. On the other hand, if Detroit’s economy suffers another blow, property values could decrease further and investors could be stuck holding the bag.
Realistically, downside protection probably is built-in in Detroit to some extent. While there’s no getting around the fact that Detroit is less stable than some alternative metros, and investing in real estate requires making some bets about a city's future economic health, it’s also probably the case that Detroit, at least right now, is closer to the floor than it is to the ceiling.
Detroit’s real estate market involves a somewhat different set of considerations than the other markets we’ve looked at in this series. Cincinnati and Rochester are more economically diverse cities whose reinventions are largely in the rear-view mirror. Morgantown, WV is a college town anchored by a Meds and Eds economy with strong downside protection.
Detroit, on the other hand, is still in the midst of its economic reinvention. While the city has weathered more formidable troubles in the past than it faces currently, its economy may not yet be as resilient as those of peer cities — and the next decade could be decisive.
Despite the uncertainties, a few features stand out:
- GDP growth is an important leading indicator that can attract migrants and capital, and Detroit’s GDP has increased by more than 28% in the past decade.
- An abundance of development opportunities in Detroit could appeal to more aggressive investors.
- The combination of affordability and demand can set up investors to capture economic growth through rent increases in Detroit’s rental market.
- Detroit attracts an outsized fraction of America’s young professional and millennial migrants, who are attracted by affordability and job prospects, and highly likely to rent. If the population and demographic trends continue, Detroit could be well-positioned to grow over the next few years.
