How Does Runaway Gentrification Happen, and Is It Good or Bad?

Gentrification can be beneficial when it happens gradually but problematic when it occurs too fast.

Gentrification is a fiercely debated topic. It raises questions of race and class; opportunity and access all tied to the deeply personal place we call home. Gentrification is a word people often throw around as a stand-in for the extremely negative—the whitening of a neighborhood and the displacement of a community—or the extremely positive—well-paying jobs and skyrocketing property values. In fact, gentrification, simply refers to the changes that happen in a neighborhood as new and more affluent residents and businesses move in. Gentrification is a double-edged sword that can be either a blessing for a community or a curse, depending on how quickly it happens. 

Increasing affluence in a neighborhood is not necessarily a bad thing. The arrival of wealthier residents to an area leads to the creation of higher-paying jobs and more disposable income within the local economy. It also expands the tax base, which enhances a city’s ability to invest in schools, parks, and other public goods. When gentrification happens in a gradual and controlled way, it has an overwhelmingly positive effect on a community.

However, gentrification is now happening faster than ever. And once it begins in an area, it’s nearly impossible to stop or even slow down. Runaway gentrification can cause rent increases of 10-20% in just a few years. Businesses tend to rush in to serve a more affluent customer base without taking into account the broader community.

This type of thinking erodes the local flavors and culture and leads to transforming the streets from an eclectic assortment of local businesses into a cookie-cutter collection of the same 8-10 shops on every block. 

The Small Things Matter

In Detroit I saw how easily the culture of runaway gentrification can create polarization between long-time residents/businesses and newcomers to a community. I saw new businesses pop up throughout the city that did not incorporate any of the local communities' needs with the products or services they were offering. Whether it was a new restaurant slanging $60 chickens, the artisanal coffee shop serving $6 lattes, or the John Varvatos store selling $120 t-shirts – there wasn’t even a decent bodega for residents, many of them lower-income, to buy nutritious food or other basic necessities. When a neighborhood is on the “rise,” there’s often a focus on businesses rather than people. I am all for attracting a customer base with disposable income, but how about an option to buy a $15 t-shirt or a $7 chicken wrap that the local community can afford to buy on their way to work or on their way home before they put their kids to bed. These examples might seem small, but these considerations, or lack thereof, affect the fabric of a neighborhood. Of course, businesses cannot try to serve everyone, but they can take into account the broader community. 

A few years back I sold one of my buildings to a tenant of mine, a gentleman who owned a video production company. He was the perfect building owner—a small business owner committed to the community. He brought in a partner and opened a small coffee shop in the front of the building. While you could get a $6 latte, he also made sure there was a $2 cup of drip coffee that the workers from the nearby stamping plant could afford. He also campaigned in the area to introduce the coffee shop to the neighbors to make sure that everyone in the community felt welcome. A cup of coffee can make a big difference. 

The cycle of runaway gentrification caused my own Detroit real estate portfolio to increase in value by a factor of 5x in less than seven years between 2012 and 2019. But while my investors and stakeholders were incredibly excited about this, I witnessed the dark side of unsustainable growth. I saw what happens to the people in a neighborhood when the cost of living increases by 500%. I watched an entire market lifecycle unfold in seven years. And the experience has convinced me that we absolutely must address the problem of runaway gentrification in our nation. To do that we must examine the source of this exponential rise in real estate prices. I found the root causes of runaway gentrification are directly linked to the way commercial real estate deals are financed.

How the Finance System Drives Runaway Gentrification

Once a market begins to gentrify, the types of people and investors involved in that market changes dramatically. It all comes down to the motivations of property owners. In Detroit, as soon as the market started to turn around and property values increased a bit, investors, banks, and real estate professionals who previously had zero interest in the city started to pile in, looking for opportunities. Two dangerous forces began to take over: 

1. SHORTER-TERM THINKING: In general, these new arrivals to Detroit came with different motivations for participating in the market. Instead of looking to provide people with quality and affordable places to live and work, their primary focus was to make as much money as possible. This created a disconnect between the goals of the developers and the local neighborhood.
2. INCREASING PRICES: As more investors and developers were drawn to Detroit it created a multiplier effect, bringing even more people into the market. This is where good ole’ supply and demand took over. Demand continued to increase as more capital flooded the area but the supply of buildings remained the same. The result: runaway gentrification. Prices started going up with no end in sight. 

For most real estate developers and investors, appreciation in property values is the primary way they make money. And the way to maximize property values is by increasing rents so the building generates additional profit.

This means that increasing rent prices are the inevitable byproduct of gentrification. It’s not possible to have one without the other. 

Case Study: Sam and Tom

Consider a developer named Sam who bought a small office building for $500,000 cash in his city. His timing was great and within two years the building’s value had doubled to $1 million. So, Sam sold the property and earned a $500,000 profit.

• Step 1: The next buyer of the building, Tom, got it from Sam for $1 million. Because the building was twice as expensive for him, Tom was not able to purchase it in cash on his own. Instead, he had to get a loan from the bank as well as convince a group of investors to put up some of the money to buy the building. The bank requires Tom to make monthly payments to pay the loan back and his investors expect to earn a return on their investment as quick as possible.
• Step 2: But with the real estate market slowing down in the area after Tom assumed ownership of the property, the value didn’t double over the next couple of years for him like it had for Sam. In order to earn a profit on his investment Tom had to find a way to sell it for more than $1 million. So, he recruited a large, low-risk national chain store with great credit as his tenant (ex:// CVS or Walgreens). This was the only option that made sense for Tom and his investors as the national chain was the only tenant with the ability to pay enough rent for Tom to cover his monthly costs. 
• Step 3: As time passes Tom’s investors start asking him when they will earn a return on their investment. Tom is feeling the pressure and the only way he can earn a profit is by selling the building for more than $1 million. Tom decides to sell the building and the only buyer willing to pay that high of a price is a larger investment fund that is focused on acquiring properties with large, creditworthy tenants already paying consistent rent.

The example above provides a glimpse of what happens behind the scenes that causes properties to be bought and sold over a short period of time. It illustrates the simple concept that the more someone pays for a building, the more money they have to earn from the property to cover their costs and earn returns for their investors. The main way to make more money and enhance the value of a property is to raise rents. This means the individuals and businesses leasing the space (and their customers) are ultimately the ones who end up shelling out more money so the landlords can sell the building at a profit. As real estate continues to become more expensive in a local market, the types of investors and building owners that enter the market change. The new actors are typically bigger firms who do not have a connection to the place where they are investing and their primary motivation to maximize investment returns. As buildings continue to be bought and sold at higher prices, owners are put under severe pressures to increase the value of their buildings, and the tenants will start to become ‘priced out.’ This is when the dark side of runaway gentrification comes to the forefront.

This cycle of escalating property values in an area generally continues until there is a recession, market crash, or other event that causes the ‘bubble to burst’ and real estate prices to fall precipitously. This is when banks stop lending, opportunities dry up, the big funds leave, and new local developers can swoop in and buy buildings for cheap. If we do not change the system from the ground up, we will continue to see the same runaway gentrification process start all over again from the beginning of a new market cycle. 

The Real Estate Food Chain

To understand runaway gentrification, you must understand the real estate food chain. In today’s real estate world, largely controlled by investment funds, properties need to be bought and sold every 5-7 years for a profit. Sam, Tom, and the large investment funds all need each other in order to exist.

Every kind of market has a food chain, which generally determines how the market is organized and how it functions. In the ocean, small fish are eaten by larger fish, which are then eaten by even larger fish. Real estate is the same way. At the beginning of a market cycle, buildings are bought by individuals and local business owners, then sold to entrepreneurs and small developers, who then sell to bigger developers and investment funds. Those bigger fish then turn around and get eaten by even bigger ones. And the property will move along the chain from one owner to the next until it’s in the belly of a massive institutional investment fund. 

Runaway gentrification happens in this system because each owner has to do certain things to the property in order to make it appealing to the next bigger fish.

The first owner has to renovate the building and invest in the surrounding neighborhood to attract people and an eclectic tenant base. The second owner then has to bring it up to code and move the tenants to longer-term contracts. The third owner needs to update heating, cooling, and lighting and replace the tenants with larger companies and chains who have excellent credit, pay higher rent, and will agree to sign leases of more than 10 years.

This need to appeal to the next level of buyer is a big part of what fuels runaway gentrification in commercial real estate. So, what can we do about this situation? We need to support local real estate developers who have a real connection to the community where they are doing business. We also need to discourage large out-of-town funds from moving in and buying large swaths of property and controlling our neighborhoods. I talk in detail about how we can slow down the gentrification process in future pieces. 

Some people argue that it’s un-American to implement any kind of policies or rules governing the free market. In fact, I used to think this way myself, so I completely understand the Laissez-Faire mentality. However, after seeing runaway gentrification take hold in the neighborhoods and communities all over the country, I’ve changed my stance a bit.

Now that technology has equipped the free market system with so much readily available information and data, it is changing local real estate markets what seems like overnight.

We need to make room for policies and checks and balances that will help create more stability for residents and small businesses as well as induce more local involvement in real estate markets across the country. But, we must do this with a centrist mindset and harness the power of the free market, capitalist system rather than suppress it. The end goal should be to create more wealth for all of the stakeholders in a given neighborhood.

What Can French Baguettes Teach Us about Economic Development?

In Paris you can’t walk down any block without passing a bakery and taking in the aroma of freshly baked bread. This city has elevated the baguette to an art form. Tourists flock from all corners of the world to browse the bakeries and cafes of Paris. 

But as an accidental real estate developer visiting the city recently with my French wife, I couldn’t help but wonder how the existence of all these bakeries is economically possible. Why hasn’t the free market replaced all but the largest bakery chains with more high margin businesses like Prada stores, high-end cocktail bars, and Patek Phillipe showrooms? 

The answer, it turns out, dates back to the French Revolution in 1798, when the citizens of Paris rioted in the streets because the bakeries were closed and there was no bread available. Bread was a staple food in Paris at the time and the people couldn’t survive without it. As a result, a series of laws were passed to help guarantee citizens the right to fresh bread. Many of these laws are still on the books today. For instance, the properties that house bakeries are preserved for bakeries—if one closes a new bakery will open in its place. Also bread must be affordable, so every bakery sells a standard baguette for no more than 1.30 euro, although you can always spend more to get the artisanal, handmade, whole-wheat loaf. But the message is clear: the people must have their bread! Half of the bakeries are allowed to take their summer vacation in July while the other half are assigned to vacation in August. The number of open bakeries in each area is closely monitored to ensure there is always bread close by. 

At first these rules can seem a bit crazy (especially to Americans). We live and die by the free market in this country, and policies that restrict the free flow of capital are generally seen as un-American and barbaric. But what’s interesting to me as a capitalist is that the Parisian bakery policies have created an incalculable level of value for the French economy as tourists from all over the world now flock to this culinary capital for a croissant and fresh baked, crispy bread. By actually restricting who can own and operate in certain spaces, and how they can be used, the French have created more wealth for everyone. 

Slowing Down the Train

Similarly, some policies on the U.S. real estate market designed to slow down runaway gentrification would benefit everyone who lives and does business in this country. One thing we should do is incentivize building owners to hold properties for longer periods of time. The opportunity zones tax legislation that was recently passed to provide tax incentives for long-term property ownership is a step in the right direction, but we need to do more. Slowing down the cycle of buying and selling would do a lot to help stabilize local markets. We should also make it easier for local developers to get involved in commercial real estate, as their incentives will tend to be better aligned with the community. And maybe every coffee shop should be required to serve a good cup of drip coffee for two dollars. 

We live in a world where real estate is treated like a tradable asset no different from stocks, bonds, crude oil, or gold. But there’s a difference between real estate and all of those other things: people don’t live, work, and play in crude oil. We don’t raise our kids in our stock portfolio. Real estate is different because it makes up the fabric of our communities and it’s closely intertwined with our everyday lives. Real estate needs to be treated with care. And, as the French example demonstrates, a more thoughtful approach to regulating the market can benefit everyone. 

Be great,

Jordan