Second String Top Performers

      This is an HTML version of an article that ran in Real Estate Forum. To see the story in its original format, click here. With competition and pricing at astronomical levels in core markets across the country—and with no signs that demand will slow—even the most conservative players are looking at secondary and tertiary markets for yield. Consider the following: Every major property sector has eclipsed peaks of 2007, according to USAA Real Estate Co. While the turbulence of the global financial crisis in 2008 drove investors into the safety of core markets, the recent calm is now driving them to venture outside the core, suggests Morgan Stanley’s report, “The Odyssey.” With persistently low US Treasury yields, historically low near-term volatility in commercial real estate returns and low capitalization rates in primary markets, according to Morgan Stanley analysts, investors are hearing the faint sound of a beautiful song of higher yields coming from non-core markets. One of the biggest questions facing core investors today is whether they should move up the risk curve and deploy capital into secondary markets. The bottom line is clear: It depends on the secondary markets and how soon you get in. Top performers in secondary markets are seeing some stiff competition. Steve Pumper, executive managing partner of Transwestern’s Capital Markets and Asset Strategies Group, warns investors to be thoughtful about which markets they’re pursuing and what businesses are in those submarkets. His advice is to focus on industries that will be successful over the next five to 10 years. “Investors need to consider if they’re in a secondary or tertiary market that’s heavily tied to a declining industry or a heavily cyclical industry,” he explains, “or if it’s one with good healthcare, tech, educational systems, energy—the types of industries and fundamentals that have a solid workforce, quality of life, etc.”  

Which Markets Offer the Best ROI?

Even in large metropolitan areas, suburbs still contain a large share of existing jobs. In the top 40 metro areas, the Urban Land Institute reports, 84% of all jobs are outside the center-city core. ULI concludes this bodes well for the future of suburbs and predicts the configuration—and reconfiguration—of suburban commercial real estate will play a role in building on the existing employment base. “More ‘suburban downtowns’ are densifying, especially if they have a 20-minute transportation link to center-city jobs, Main Street shopping and their own employment generators,” the ULI report reads. “These suburbs exhibit many of the attributes of an 18-hour city,” while less costly than the densest coastal markets. Three out of four Millennials preferred such close-in locations if they considered suburban choices, according to ULI. ULI offered some working examples of cities outside the core that make attractive investments. San Antonio, Dallas, Houston, San Diego and Phoenix have suburban-dominated job growth, while Denver’s growth marginally favors its suburbs. Chicago, meanwhile, is seeing suburban office building vacancies decline. Andrew Nelson, chief economist at Colliers International, cites significant upside in 18-hour cities such as Atlanta, Austin, Charlotte, Dallas, Denver, Nashville and Seattle because they’re poised for superior growth in employment and gross metro product. “There has been much more moderate cap rate compression in these areas than in traditional gateway cities, providing the opportunity for greater yields to those priced out of core markets,” Nelson comments. “As the economy has demonstrated stability and interest rates remain near historic lows, investors flushed with cash have shown an increased tolerance for risk, and grown more comfortable in secondary, tertiary and suburban markets.” Francis Greenburger, CEO and founder of Time Equities, says the scenario constantly changes. He has his eyes on Midwest cities like Chicago and Detroit. Pumper, though, is seeing acquisitions in Southeast cities like Birmingham AL; Memphis and Nashville; Greenville, SC; and Tampa, Orlando and Jacksonville, FL. “Markets have always been viewed based on the size of their MSA, so larger cities were considered primary,” says Ella Shaw Neyland, president of Steadfast REIT. “But today, markets are being viewed by the rate that jobs are being created since employment is a major driver of demand for apartments.” Neyland points to Austin, which has some of the highest US job growth driven by light manufacturing, technology, financial services and research—yet it has only about 1.8 million residents. “Austin was once considered a secondary market, but by all the important metrics to a successful apartment community, it’s ground zero,” she says. “People need to rethink the old standards.” As for Paul Ahmed, senior vice president at Walker & Dunlop, when he thinks of primary and tertiary markets in Florida, he sees Fort Myers as a tertiary market and Orlando, Miami and Jacksonville as primary markets. “Orlando continues to be a favored market,” he says. “In tertiary markets, lenders will look at and loan on them, but maybe they will do it more conservatively. Some won’t loan there at all.”  

What Asset Types to Watch

Some asset types seem to perform better than others. Time Equities is actively acquiring retail properties, suburban office spaces and select industrial assets. Greenburger says properties that present long-term potential and strong cash flow fundamentals are often most attractive as investment opportunities. “We have a well-occupied regional mall in Utah under contract for $70 million at a 9.5%-plus in-place cap rate,” he says. “We are also buying a 50% occupied suburban A-quality office building for $60 per square foot in New Jersey at 8.5%-plus cap rate on existing occupancy.” Nelson suggests that investors seeking upside target assets with a diverse tenant base to protect against sector-specific downturns, assets with near-term lease rollovers and those with upgraded tenant amenities, whether in gateway markets or 18-hour cities. Drilling down into specifics, multifamily has clearly outperformed office, industrial and retail assets in this cycle and in core and non-core markets in terms of volume. Portfolio and entity-level plays earlier this year, such as Starwood Capital Group acquiring Equity Residential’s suburban portfolio, Starwood Capital and Milestone Apartment REIT acquiring Landmark Apartment Trust and Harrison Street acquiring Campus Crest, have buoyed multifamily in non-core markets. “The drop-off in the office, industrial and retail sectors was really related to the fact that there weren’t many, if any, portfolio deals so far this year,” Pumper says. “We’ve also seen drop-off in sales volumes in New York, Washington, DC and San Francisco because investors are taking a pause to determine where we are in the cycle given that cap rates in those markets are at historical lows. These investors are trying to decide where to deploy their capital to maximize returns, and that’s driving flight to secondary or tertiary markets.” Marcus Suarez, senior vice president at Hunt Mortgage Group, says a lot of the decision making on projects in tertiary markets has to do with the operator. His firm looks at network and liquidity. “People work and live there and raise their families there,” Suarez says. “We’re going to follow our borrowers to these markets. We’ll get aggressive in the right secondary and tertiary markets.”  

Competition Rising in Non-Core Markets

Competition is starting to heat up in non-core markets but there are still many deals to be made with 7%-plus cap rates. Investors can purchase an asset in a secondary market at a 7% to 8% cap rate, invest in renovations, actively push to bring it to full occupancy and sell for a nice profit as the market gets frothier. “There is competition in the secondary and tertiary markets, but we can remain competitive within our buying criteria in these areas, which is harder for us in ‘core’ markets,” says Greenburger. “We’re not seeing an increase in pricing. I anticipate that may change after we continue acquiring in these submarkets.” According to Nelson, cap rate compression has been far more subdued than in the gateway markets, although rising as the restrained new construction over the past several years limits quality new product for purchase. “While Millennials have been deferring marriage and family formation, they will eventually follow their parents’ path out of the CBDs to the suburbs, though a different model of suburban living,” Nelson says. “Eighteen-hour cities and suburban areas with a vibrant ‘downtown’ and mass transit options will see the heaviest competition.”  

Finding Attractive Deals

Sentiments for the investment sales sector are bullish for the next 12 to 24 months. Interest is growing for assets in non-gateway cities, Nelson says, as they appeal to investors’ desires for income and growth while offering an alternative from the high-cost barriers in gateway markets. So how do investors find the best deals? “Buying well for us means being flexible, by being willing to look at and understand a variety of property types, markets and deal structures,” says Greenburger. “Being a reliable and fair buyer who closes and does what its promises is also crucial to continued long-term success in this industry.” How long will non-core markets be in vogue? Like many questions regarding the future of commercial real estate markets, the answer is, “it depends.” Specifically, it depends on the industries that fuel it. Industry watchers agree investors should focus on markets with good quality of life and labor force because that will attract companies to stay in that market or relocate there. Ultimately, investors are looking to secondary and tertiary markets partly for deal flow and partly for yield. Savvy investors are leaving primary markets and picking up anywhere from 50 to 75 basis points by going to secondary or tertiary locations. “Those markets were lagging thus far in the recovery, so now they have more runway ahead of them into the recovery,” Pumper says. “This means investors can get better pricing on the acquisition side on assets with good market fundamentals ahead of them to outperform returns in other markets.”