Outside the Core: Big Fish, Small Ponds

Landmark Center is a 304,946-square-foot, class-A office tower in Indianapolis’ CBD. Fairbridge Properties paid $21.5 million for the 12-story building.

  This is an HTML version of an article that ran in Real Estate Forum. To see the story in its original format, click here. Commercial real estate prices have skyrocketed and are not expected to dip in the near future. In fact, it’s not uncommon for even class A properties to sell at A-plus rates because of the heavy competition for these prime assets. It’s well known that core markets have historically provided stronger and more consistent returns over the long term. Yet these days, secondary and even tertiary markets are enticing more strategic investors, looking to achieve preferred yields through value-add opportunities—to bet on strong assets in non-core markets. “The days of ‘pass the parcel’ are over, and long-term secure investments in core markets will be the norm,” says John Friedrichsen, global chief financial officer of Colliers International Group. “At the other end of the risk spectrum, large volumes of capital already raised will increasingly seek out opportunities in tier two cities and recovering markets.” So the key questions are: Who are the big fish that have chosen to enter secondary and tertiary markets and what’s driving them there? What challenges are they facing? And where’s the sweet spot—that balance between buying into core markets and settling down in non-core cities? One major segment of the market attracting bigger players is multifamily. In fact, Real Capital Analytics reports that apartment REITs as a whole are spending more money in secondary markets than in the core these days. On the private side, Waterton, an investment and property management company focusing on multifamily and hospitality assets, recently completed the acquisitions of Parkside at Firewheel, a 594-unit rental community in Garland, TX, and the 426-unit Addison Park in Charlotte, NC. According to Philip Martin, vice president of market research, the company in the past year has also made acquisitions in such cities as Ft. Lauderdale, Orlando and Raleigh, NC. For its part, HSA Commercial Real Estate, a full-service firm active in brokerage, management and development, is pursuing industrial projects and investments in several secondary markets.

“Many of these smaller markets have experienced strong job growth, oftentimes bolstered by pro-business initiatives as well as infrastructure improvements.”—Phillip Martin, Waterton

“We recently completed the lease-up of Gateway Industrial III, a 220,000-square-foot spec distribution center in Plainfield, IN, immediately southwest of the Indianapolis International Airport,” says Bob Smietana, HSA Commercial’s vice chairman and CEO. “Our pipeline projects include a smaller 150,000-square-foot spec warehouse that will be built adjacent to Gateway Industrial III, the fifth and final building our firm plans to develop in the Gateway Business Park.” The firm also has developments planned this year in both Nashville and southeast Wisconsin. Fairbridge Properties, a privately held real estate company specializing in acquiring undervalued commercial properties, is currently betting on the office markets of Cincinnati, Salt Lake City, Denver and Portland, OR. As Dmitry Gordeev, Fairbridge’s managing principal and founder, sees it, secondary and tertiary office markets are just at the beginning of their cycle. Having lagged behind the primary markets, he says the potential income opportunities in these locations are higher than in primary markets. “A quick comparison of the cap rates for office assets in Cincinnati versus Chicago serves as a nice example,” Gordeev says. “According to the CBRE North America Cap Rate Survey for the second half of 2015, the cap rate for a class A stabilized property in Cincinnati is 8.25% to 8.75%, whereas the cap rate for a class A stabilized property in Chicago is 5% to 5.5%.” Even space occupants are finding wins in the non-primary markets. By pursuing deals in cities like Indianapolis and Nashville, says Smietana, “users have an opportunity to secure newly constructed space not only at a lower rate, but in many cases, in states where it’s more affordable to do business.” According to the Urban Land Institute and PricewaterhouseCoopers, many in the business feel that time is on the suburbs’ side. In the firms’ “2016 Emerging Trends in Real Estate Report,” analysts point out that the major argument is that “the deferral of marriage and family formation by Millennials, and the related preference for downtown living in denser, more active ‘mating markets,’ is just that—deferral. Eventually, the logic goes, generation Y will follow the baby boomers’ path and head to the suburbs in the child-rearing years. That may very well be, and numbers are on the side of that argument as well.”

HSA Commercial Real Estate recently completed the lease-up of Gateway Industrial III, a 220,000- square-foot speculative distribution center in Plainfield, IN, located immediately southwest of the Indianapolis International Airport

As the RCA report revealed, secondary and tertiary markets have become especially attractive to multifamily investors due to their relative yields. With rising rents and occupancies pushing up values in core markets, Martin has seen a greater number and variety of investors—including those that did not previously have a presence in secondary and tertiary markets—seek out higher returns in these cities, leading to heightened competition. “We remain focused on primary markets, but do selectively invest in secondary markets in close proximity to larger metros within the same region,” says Martin. “Many of these smaller markets have experienced strong job growth, oftentimes bolstered by pro-business initiatives on the city and/or state level, as well as infrastructure improvements such as expanded highway networks and public transportation systems that improve accessibility.” Waterton looks for multifamily rental markets that offer relative affordability compared with the alternatives—such as for-sale housing—not only in that city, but in other markets nearby. As part of this process, Martin takes into account everything from demographic trends to the age of a city’s existing housing stock to the firm’s ability to add value through strategic renovations. He explains, “We also consider to what extent we’re able to meet pent-up demand in terms of pricing, services and amenities, and the desired lifestyle as more people are drawn to the flexibility of renting.” According to Smietana, the secondary markets HSA is pursuing all have a few common elements: a good transportation system, business-friendly environment, skilled employment base and a less saturated development market. Yet as with all opportunities for update, there comes a potential downside. there are clear risks and challenges in venturing beyond the core. As his firm has tested the secondary market waters, Martin has discovered many of them have fewer barriers to entry in terms of land availability, land acquisition and development costs, zoning and entitlements and other potentially deal-breaking factors.

“For users, these markets present an opportunity to secure newly constructed space at a lower rate and, often, in states where it’s more affordable to do business.”—Bob Smietana, HSA Commercial Real Estate

“That makes them more susceptible to incremental competition,” Martin says. “And because they tend to be less dense than core markets, secondary and tertiary markets sometimes offer a greater variety of housing options, including single-family homes, condos and townhomes that could pose a threat to apartment demand over the long term.” What’s more, he says, the economies of these smaller cities can be less diversified, with fewer industries or higher-paying jobs than what you might see in a primary market. The result: institutional investor interest is sometimes lower due to the inherent risks associated with these markets. For some players, the higher returns offered by a particular market simply aren’t enough to offset the potential challenges. “A critical part of the underwriting process for a secondary-market asset is to make sure there is enough business activity in that market in order to attract credit-rated tenants,” says Gordeev. “Another key factor for attracting high-credit tenants is to acquire assets that are best in class. At the same time, the asset needs to be bought at below replacement cost. Finding an asset that meets all of these criteria can be challenging.” Some areas have more of these characteristics than others. Even in the big metro areas, the ULI-PwC report reveals suburbs represent a major share of the existing jobs base. In the top 40 metro areas, the report indicates, 84% of all jobs are outside the core, giving investors optimism for a suburban future. The report shows that in markets like San Antonio, Dallas, Houston, San Diego, Phoenix and Chicago, the suburbs are dominating the growth. Generally speaking, experts agree that 18-hour cities like Portland, Denver, Atlanta, Seattle and Charlotte, NC are also strong bets. In addition to expanding in the markets where it already has a presence, including Indianapolis, Nashville and southeast Wisconsin, Smietana says HSA Commercial is exploring opportunities in similar secondary markets throughout the Midwest that share critical attributes such as a strategically valuable location for logistics and access to a skilled labor pool. Martin has his eye on investments in markets that are in the path of sustainable metro and regional growth and close to the strongest primary markets. He points to Tacoma from Seattle, Boulder from Denver, Providence from Boston, Sacramento from San Francisco. “These ‘spillover markets’ allow us to build on the familiarity we already have with a particular city,” he says, “while pursuing opportunities in neighboring markets with similar supply and demand drivers, relatively attractive affordability and, in many cases, less competition.”

“At present, core market deals tend to be value-add or appreciation plays. In order to create a consistently high cash flow, we’re buying more assets in secondary markets.”—Dmitry Gordeev, Fairbridge Properties

Despite the migration to secondary markets, heavy hitters are not turning their backs on the long-term promise of the core. According to LaSalle Investment Management, high quality, stabilized, long-leased assets are less sensitive than higher risk strategies to market volatility. With high occupancy and a small share of leases rolling over each year, the firm reports, income is more stable and liquidity is likely to hold up better in top tier locations. “We are still playing in core markets and are constantly looking for new acquisitions in these cities,” says Gordeev. “At the present time, however, core market deals tend to be value-add or appreciation plays. In order to create a consistently high cash flow, we are currently acquiring more assets in secondary markets.” Martin agrees. His recent acquisitions have targeted cities like Chicago and Los Angeles. The keyword at Waterton is diversity because a diversified portfolio helps the firm navigate various economic cycles. “By thoughtfully allocating investment capital across a combination of primary and secondary markets throughout the US,” he says, “we’ve been able to build a high-quality, sustainable investment portfolio with cash flows that offer an attractive risk-reward profile.” And that’s the ultimate motivator behind many companies that are expanding beyond core markets.