They say good things come in small packages. The same holds particularly true in commercial real estate – particularly in the multifamily segment.
While many foreign and institutional investors pour money into the big city gateway markets, investors with boots on the ground in local secondary and tertiary markets are finding value properties with superior cap rates and growth opportunities.
For experienced real estate investors, not all markets are created equal. While gateway market investors – content with 3-4% cap rates – pursue only core and core-plus opportunities; value properties with the highest upside potential lie in the smaller markets.
For experienced investors seeking superior returns, secondary and tertiary markets are the places to go.
Much has been made of the effect COVID-19 has had on foreign and institutional investments. With foreign and institutional investors sidelining investment in the gateway markets, the assumption was that these investors were expecting a squeeze in cap rates due to an expected decline in rental demand.
However, what happens in the gateway markets doesn’t necessarily carry over to the secondary and tertiary markets.
The problem with comparing primary markets with secondary markets is even as high rent properties in gateway markets are the first to suffer in a recession, the same won’t necessarily hold in the secondary markets.
The reverse may hold as evidenced by what happened during the Great Recession as renters fled high rent gateway markets for inland secondary markets. So, as commercial real estate cools in the primary markets, the same may not hold in secondary and tertiary markets.
The following summary highlights what sets primary markets apart from secondary and tertiary markets:
- Primary/Gateway Markets. Primary markets – including New York, Los Angeles, Chicago, San Francisco, Boston, and DC. – are centers of long-established commerce and population. They are also the focus of intense investment and competition by some of the largest private equity funds, REITs and foreign investors in the world.
- Secondary Markets. Secondary markets, or non-gateway cities, which include Houston, Portland, Raleigh-Durham, Salt Lake City, Atlanta, Charlotte, Dallas/Fort Worth, Nashville, Denver, Miami, Seattle, and Austin, offer the amenities of the primary markets without the dense population. Populations typically range from 1-5 million and these markets have recently experienced surging populations and booming economies.
- Tertiary Markets. Tertiary, or emerging, markets have steady but controlled job growth, populations typically under one million people, and a combination of traditional and alternative economic drivers.
Population Growth –
Cap rate compression in primary markets is a product of intense competition by deep pocket institutions and foreign investors leaving the growth opportunities in the inland markets.
According to real estate research firm CoStar, commercial real estate cap rates in the gateway markets of Boston, N.Y.C., D.C., Chicago, San Francisco, and L.A. have fallen to a range between 2-4%, down from peaks of around 4-6% in recent years due to increasing institutional and foreign competition.
Ignored by many institutional and foreign investors, cap rates in high-growth secondary markets have not seen the same compression, holding steady between 5-7% because of steady population growth.
The advantage of secondary markets is the steady flow of workers fleeing the big cities for secondary markets. This migration is in full swing from a workforce attracted to high-growth secondary markets for the lower cost of living and higher quality of life, with typically better tax and regulatory environments more friendly to businesses.
Migration from gateway markets has led to corresponding job gains, which have led to strong increases in commercial real estate rent rates – especially in the multifamily segment. According to researchers at the Apartment Guide, the ten cities with the highest rent growth in 2019 were in secondary markets.
For consistent income and above-market returns look to high-growth secondary and tertiary markets that don’t act like primary markets because their demographic and economic makeups are different.
High-growth markets are less volatile in downturns and bargains in these markets can still be found with boots on the ground – offering stronger growth potential due to a lower cost of living and lagging supply.