Reports of U.S. Cities' Demise Seem Greatly Exaggerated

During the darkest days of the COVID-19 pandemic, media reports detailed what appeared to be a sweeping migration out of U.S. urban centers. A theory developed that the pandemic had perhaps changed Americans’ view on city living and that, post-pandemic, this exodus from cities could be permanent. It was little surprise when apartment real-estate investment trusts (REITs) and other assets tied to urban living came under pressure.

But as businesses open again, could investors simply have been under the influence of what behavioral psychologist Daniel Kahneman calls WYSIATI, or “What you see is all there is”? In other words, a cognitive bias in which humans subconsciously draw conclusions solely on immediately available information. 

“The truth on city populations, in our view, appears more nuanced, and more positive,” says Michael Zezas, Head of U.S. Public Policy Research at Morgan Stanley Research. “Cellphone tracking data show that not all cities lost population, and many only lost people to neighboring counties, reflecting the enduring economic viability of those areas.”

Further, any outmigration may prove temporary. A common thread among people fleeing cities was that they had the means or the mobility to leave, and that the pandemic was the primary motive. “With the pandemic's end in sight, that motive could wane,” Zezas adds.

To better understand the pandemic's impact, Morgan Stanley Research analyzed multiple data points in dozens of U.S. cities to create a framework around city health. Ultimately, the results help assess the risks and opportunities for REITs, housing credit and municipal bonds.

Overall, 18% of consumers moved since February 2020, largely in higher and lower income brackets.

Although U.S. Census data is often used to gauge population growth, the once-in-a-decade cadence makes it a blunt instrument. To get a more timely read on population changes, Morgan Stanley analyzed cellphone ping data at the zip-code level in 46 metro areas, while also factoring for apartment rents by geography, office rent growth and sublet availability.

The key finding: Population shifts varied by city, in some cases significantly. To illustrate this, Morgan Stanley assigned a collection of cities into four categories:

• Booming cities—Five U.S. cities—Jacksonville, Fla.; Memphis, Tenn.; Phoenix/Mesa; Albuquerque, N.M.; and Atlanta—not only maintained population growth through the pandemic, they saw rent growth in offices and apartments. “These cities are more than temporary escapes,” says Zezas. “They are growing for strong intrinsic and durable reasons.”

• Rebounding cities account for 21 metros in the analysis, including San Antonio; Charlotte, Tenn.; and Las Vegas, to name a few. These cities lost population but show nascent growth signs via cellphone data, as well as positive inflections in office and/or apartment rents. “People may have left the core of these cities because they had the means to relocate, but either will return or remain residents of periphery communities,” Zezas explains.

• Steady cities lost population and now show mixed signs of rebounding. “These cities could easily end up in either of the other three categories and bear close monitoring,” says Zezas. Many of the nine cities in this category, such as Austin, Texas; Portland, Ore.; Seattle, Wash.; and Denver, were booming prior to the pandemic.

• Lagging cities showed below-trend growth before the pandemic and have yet to show consistent signs of a rebound. It's likely no coincidence that the four cities in this bucket—Los Angeles, San Francisco, San Jose, Calif.; and New York—are among the largest and most expensive U.S. markets.

From a market impact perspective, the data pointed to an attractive outlook for apartment REITs, although local market dynamics will always be a driving force.

“Apartment fundamentals are improving quickly, even in major coastal markets, as concessions are rolled back, given a rebound in demand,” says Richard Hill, head of Morgan Stanley's U.S. REIT Equity and Commercial Real Estate Debt research team.

Apartment REITs are trading around historically high multiples and five times their longer-term averages. “But the world is more expensive,” says Hill, noting that the sector trades below 10-year and 15-year average premiums, and it also benefits as an inflation hedge.

Apartment are trading at relative premiums to the S&P that are below historical averages

The forecast for office REITs looks a bit cloudier. Cities may rebound, but uncertainty around hybrid work models could mean risks. “The office is not dead, but this next expansion cycle will be shorter and lower for office landlords,” says Vikram Malhotra, equity analyst covering the U.S. Office REIT industry, cautioning that while valuations may seem cheap "the easy money has been made."

Indeed, historic price-to-earnings multiples could be misleading, as corporate tenants factor work-from-home arrangements into their long-term leasing plans.

U.S. office vacancy rates have moved roughly 400 basis points higher

Broadly speaking, the pandemic has been positive for housing-related assets: Low interest rates, strong consumer balance sheets, and positive demographics have driven demand for single-family homes in most major markets. More than $400 billion in purchase-mortgage originations in both the third and fourth quarters of 2020 resulted in the highest year of new loans in at least 17 years.

Strong home price appreciation is leading to higher prepayment speeds and lower delinquencies—and that means strong credit outcomes for nonagency residential mortgage-backed securities, says James Egan, co-head of U.S. Securitized Products Research. Again, the outlook varies by market: Home prices are surging in many smaller cities and suburbs, while price appreciation has been more muted in densely populated areas.

State and local governments are only beginning to understand the economic implications of the pandemic. Munibond spreads—which measures the yield difference between two bonds—are already thin, meaning investors should proceed with caution.

“Shrinking populations are generally a reliable, though lagging, negative indicator for municipal bonds,” says Zezas. “Fewer residents often means reduced revenues and ultimately a higher cost of borrowing for muni issuers who have to offer higher yields at lower prices.”

For more Morgan Stanley Research on the outlook for U.S. cities, ask your Morgan Stanley representative or Financial Advisor for the full report, “A Tale of 4 Cities" (June 3, 2021). Plus, more Ideas.