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Risky Business: Investors Are On The Hunt For Better Risk-Adjusted Returns In Secondary Markets

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Commercial real estate investors on the hunt for solid risk-adjusted returns are bypassing top-tier markets to bet on assets in burgeoning secondary markets.

Though the U.S. economy remains strong with no signs of an immediate downturn on the horizon, key macroeconomic fundamentals — such as population growth, domestic migration and strong employment growth — have favored select secondary metros above primary markets at this late stage in the real estate cycle

Austin skyline ATX
The Austin skyline

“Employment is growing fastest in secondary and tertiary markets and companies are expanding outside of the gateway markets as affordability concerns have hurt cities such as New York, San Francisco, Los Angeles, Boston and Washington, D.C.,” Yardi Manager of Institutional Research Chris Nebenzahl said. “A number of major tech companies are opening offices in Seattle, Denver and Austin.”

Trepp has determined the three secondary metropolitan statistical areas most ripe for commercial real estate investment are Austin-Round Rock, Texas; Orlando-Kissimmee-Sanford, Florida; and Nashville-Davidson-Murfreesboro-Franklin, Tennessee.

Trepp Senior Managing Director of Applied Data, Research and Pricing Manus Clancy said each of the top-ranked MSAs are benefiting from thriving local economies and low loan delinquency rates. 

“There’s been real demand for space in college towns. Austin is really the home to the University of Texas, and you found it being kind of a magnet for tech firms recently,” he said.

One AT&T Center in St. Louis
One AT&T Center in St. Louis

Orlando is theme-park centric and the strong economy has helped that continue to outperform. Nashville is another strong market being helped by corporate relocations — people looking to move from high-tech space in the North and Midwest down there — the latest being Alliance-Bernstein announcing they are going to move their headquarters to Nashville,” Clancy said. 

Trepp ranked 20 secondary MSAs by dissecting several factors, including population growth and other key demographic trends, increased commercial development activity, access to capital, loan delinquency ratings and loan issuance growth. 

The lowest-ranking secondary MSAs on Trepp’s list were Kansas City, Missouri, St. Louis and Cincinnati. All three have high delinquency rates — 10.66%, 25.76% and 12.91% respectively, though Clancy said that may not speak to the overall strength of those markets. 

“It can just be one or two loans that are problematic that can make a market look worse than it is,” Clancy said. 

In Cincinnati, a $53.6M loan in foreclosure at 255 Fifth St. was large enough to bump the MSA down to No. 20 in the rankings. In Downtown St. Louis, a $107M loan for One AT&T Center is distressed, according to Trepp data. 

“Something that big in a market that is not top five or top 10 really moves the needle in terms of underperformance,” Clancy said. 

Worth The Risk? 

Trepp ranking of top secondary MSAs
Trepp's ranking of the top secondary MSAs for CRE investment

Research shows cap rates for commercial properties in secondary markets tend to be higher than the national average. Though this would suggest higher volatility for assets in those metros, Nebenzahl said the long-term value of assets in tier-two and tier-three markets is often found to be more stable than in gateway cities

For investors willing to pay more for strong performing assets that generate solid long-term income growth, this is encouraging news.

“Investors have been shifting into secondary markets because of the greater possibility for yield and income growth,” Nebenzahl said. “The urban core of 18-hour cities resemble many of the gateway markets and investors are recognizing opportunities in these markets. Urbanized suburbs are also popping up in a number of cities, with highly walkable and amenitized neighborhoods presenting opportunities for institutional real estate investors.”

Transaction volume has been on the rise in secondary and tertiary markets despite the added risk. Compressed cap rates — when an asset increases in value despite the fact that its net operating income remains unchanged — have eaten into cap spreads for assets in gateway cities, making it increasingly difficult for institutional players to get a solid return on investment. 

“Some funds might not even be able to invest in gateway market properties at this point as the projected returns might be too low to meet their fund’s required [internal rate of return],” Ten-X Senior Quantitative Strategist Chris Muoio said. “Another more fundamental factor is many of the gateway markets are seeing the heaviest supply additions, resulting in dampened NOI expectations relative to other markets."

Industrial Sector Outperforms In Secondary Markets

Risky Business: Investors Are On The Hunt For Better Risk-Adjusted Returns In Secondary Markets

With e-commerce retailers fueling demand for more industrial product to be built in peripheral and rural markets, secondary and tertiary markets are experiencing tighter market conditions and stronger rent growth than that of primary markets, Cushman & Wakefield Vice President and Head of Industrial Research Jason Tolliver said. 

With roughly 135.9M SF of new supply expected to deliver in primary markets this year, rents have increased 3.5% year-over-year to $5.46/SF. At the same time new supply in secondary metros is anticipated to hit 102.3M SF this year, with rents advancing 4.6% to $8.62/SF year-over-year. 

“Such strong growth and an uptick in leasing activity within smaller markets is spurring increased competition for limited space and encouraging needed development,” Tolliver said. 

Industrial development in primary markets was one-and-a-half times more aggressive than that of secondary or tertiary metros between 2015 and 2017, C&W reports. U.S. net absorption overall is expected to exceed 250M SF this year, and should remain at a similar pace through 2020, Tolliver said. 

“Looking ahead, Cushman & Wakefield expects that industrial will continue to boom and that secondary and tertiary industrial markets will continue to post solid growth numbers,” he said.