12 years have now passed since Friedman predicted in his seminal work, “The World is Flat,” that 21st Century globalization would cause capital concentrations to disperse in order to take advantage of cost advantages across the developing world.  Yet in a relatively short amount of time, it has become apparent that the forces of agglomeration, which cause innovation industries to locate in close proximity to one another and form knowledge hubs, far outweigh the increases in salary and real estate costs associated with doing so.

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This paper explores 3 of these forces of agglomeration and their impact on creating and reinforcing innovation hubs. Understanding these forces is of vital importance for us as real estate investors, as they hold the key to making cities more economically successful.  

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Market Thickness

Over the past 20 years, we have seen both technology companies and tech workers flock to Silicon Valley from around the world.  Workers claim they go because “that´s where the jobs are” while companies claim “that’s where the talent is.”  At first glance this appears illusory.  Aren´t supply and demand roughly in equilibrium?  If Topeka, Kansas has 100 software positions and 100 skilled software employee in the labor market, aren´t the odds of finding a position the same they would be in San Jose California where there might be 10,000 jobs for 10,000 skilled employees?

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The truth is that it is highly preferable for both sides to be in the larger market.  This is because innovation workers and positions cannot be reduced as we might if we were talking about supply and demand in widgets or factory workers.  There are thousands of specializations and areas of expertise unique to each job and each potential employee, making them impossible to commoditize.  Access to a larger job market not only improves the workers´ chances of finding the position that can utilize their specific skill set, but by improving the quality of the match, they are also able to demand more in compensation.

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To illustrate this point, imagine you are choosing between two dating websites.  Both have an equal ratio of men and women, but the first has 100 members while the second has 10,000.  You might be tempted to conclude that the sites are equivalent because of their ratios, but of course they are not.  The odds that someone will find exactly the person they are looking for—looks, values, interests, humor, goals--are much higher in the larger site.

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Ecosystem Effects

The second of our forces of agglomeration involves the larger ecosystem which businesses operate.  When a profitable industry begins to conglomerate in a single area, professional service industries tend to appear in order to support it.  It is no accident that Raleigh-Durham, a hub for R&D biotech, has some of the top patent attorneys in the life science field, and that competition between them drives their prices down. 

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Venture Capital access is an additional and vital component of this ecosystem.  Consider Sequoia Capital, early backers or some of the most iconic startups in the history of high tech: Google, Oracle, Apple, YouTube, PayPal and Cisco.  Executives at Sequoia used to claim that they would only consider financing companies that are located within a twenty minute drive from their office.  Are we to imagine it was purely coincidental that all these iconic companies simply happened to sprout up inside this preferred radius?

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Why, in a world of fast communication and cheap flights, should a venture capital firm hold such strong preference for physical proximity?  The truth is there´s a lot of support, team building, and relationship building which goes into building a successful startup that extends far beyond writing a check. 

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Knowledge Spillover

Business executives have a long cited a need to “be close to the action” as an explanation for relocating to innovation centers.  Intuitively, this makes sense.  Smart people like being around smart people.  Until recently however, it was difficult to prove whether knowledge spillover offered any demonstrable benefits outside of employee well-being. 

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A recent study examined patent citations to show the power of knowledge spillover within a local market.  When filing for a patent, an inventor must list all previous inventions that their idea builds upon.  These citations offer a great way to track the flow of knowledge.  The research found that a strong local bias existed.  Inventors were much more likely to cite someone from their local market, and even more likely if that person worked in the same building, or utilized the same elevator.

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While information can be passed freely and instantaneously around the globe, it appears that ideas still incubate locally, creating a need for companies to establish themselves within these incubation environments if they want to be at the forefront of their respective industries.

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Investment Implications

As real estate investors, perhaps the most important driver of investment success is market selection.  After all, a rising tide lifts all boats, while a declining market will drag down even the best site.  Therefore, the ability to recognize early signs of agglomeration can be of immense value to us, as nothing buoys a market over the long term like the presence of a high tech innovation industry. 

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What could be of more interest to a real estate investor than a phenomenon which makes tenants virtually immune to increases in rental prices?

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AW Hopewell Properties strives to be at the forefront in identifying markets which are positioned to build and maintain a strong competitive advantage within an innovation industry.  As we´ve seen, once a knowledge hub has established itself, it is extremely difficult to displace.

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1. For more information on this topic, check out Enrico Moretti´s "The New Geography of Jobs"