Market analysis

Small(er) Markets, Big Opportunities

Investors leave core cities in search of higher returns.

By Rich Rosfelder |

Commercial real estate investors are ready for a bit of risk. According to a 2011 Colliers survey, more than half of U.S. investors surveyed are prepared to move out of their comfort zones in search of higher returns. Their adventures will lead them straight to non-core markets.

And with pricing still below replacement costs in many second- and third-tier cities, properties that fit investors’ criteria are already generating a lot of interest. Transaction volume in secondary and tertiary markets reached more than $57 billion in 2011, according to Real Capital Analytics, which tracks property sales valued at or above $2.5 million. Private investors were by far the most active, closing 2,398 deals totaling nearly $22 billion. Cross-border investors, non-listed real estate investment trusts, and equity fund investors accounted for many of the remaining transactions. As expected, multifamily properties were the primary targets.

Though bargains can be found in some secondary and tertiary markets, today’s savvy investors aren’t just looking at price. “They’re tired of waiting, and they want to find properties with good leases, strong tenants, and a good ROI,” says Jim Baker, CCIM, president of Baker Commercial Real Estate in Jeffersonville, Ind. “Plus, inflation may be just around the corner, and having assets is better than having cash.”

If it’s the right asset in the right market, that is.

Where the Action Is

Aside from the promise of higher yields, what’s drawing investors to secondary and tertiary markets? The simple answer is jobs — and the prospect of more jobs. Cities with strong financial, energy, trade, or biotech sectors and population growth are generating the most interest, says Peter Slatin, editorial director and associate publisher of Real Capital Analytics. He mentions Charlotte, N.C., Madison, Wis., Minneapolis, Huntsville, Ala., and Inland Empire, Calif., as target markets.

Proximity to primary markets is also a factor. For example, “Miami is experiencing a construction boom,” Slatin notes. “That benefits Fort Lauderdale, Fla., which saw several major transactions last year.”

With their strong economies and universities, Pittsburgh and Austin, Texas, continue to be favorites as well, particularly among office investors, Slatin adds. Downtown Pittsburgh’s largest office building, the 2.3 million-sf U.S. Steel Tower, was purchased by an investment group last year for $250 million, which was well below replacement cost, according to RCA.

Large real estate investment trusts, foreign investors, institutional investors, and private individuals with cash were all active in Austin in 2011, says Bob Rein, CCIM, associate vice president with NAI REOC in Austin. He focuses on class B and C office properties in the $7 million to $10 million range. “Given the higher degree of risk and the cost of capital increases, smaller investors are seeking a 15 percent to 17 percent internal rate of return on these assets,” Rein adds.

High capitalization rates, market stability, and university-related projects are also drawing investors to western Massachusetts. Mark Berezin, CCIM, of Infinity Real Estate Group in Holyoke, Mass., cites the Massachusetts Green High Performance Computing Center as the latest boon to the area. A collaboration between five universities, state government, and private industry, the Holyoke-based project is expected to create 600 construction jobs, 130 research jobs, and 13 permanent positions at the center. “We’re working with multifamily and mixed-use investors from Boston, New York, and California who have discovered our market through Internet research and know that the focus on green energy and education is going to be a significant component of the economy of the future,” Berezin says.

Urban infill sites are a big draw for investors in Charleston, S.C. On King Street, a popular shopping destination, “national powerhouses such as GreyStar and Regent Partners aggressively compete with regional and local investors for the best land, hotels, former public buildings, and historic properties,” says Richard B. Morse, CCIM, of Palmetto Commercial Properties in Charleston. With retail rents around $40 per square foot, office rents approaching $30 psf, and hotel occupancies at 80 percent to 90 percent, King St. is seeing unprecedented investment activity, he adds.

But Morse is taking a measured approach. “My goal is to become the investment expert for historic mixed-use properties on or near King St. in the $500,000 to $1.5 million range,” he says. “While they may not be the most expensive types of investment properties trading right now in our market, I believe they have less risk, higher potential rental income, and are simply more enjoyable to own.”

Under the Radar

Investors are clearly interested in non-core markets. But to close deals, first you have to find them. “Around two-thirds of larger transactions are happening with off-market properties,” says Liam Murphy, CCIM, of Hayes Commercial Group in Santa Barbara, Calif. “A lot of brokers used to just focus on getting listings; now they need a relationship with a capital source or acquiring party.”

In Murphy’s market, corporations that operate investment funds are adjusting their risk profile and selectively offering properties to “qualified capital sources,” which usually means other corporations. This can be frustrating for aspiring real estate investors that want higher returns but aren’t privy to information about available properties.

Discovering investment opportunities in secondary and tertiary markets often requires a more proactive approach. “I research buildings that aren’t for sale,” Rein says. “If it’s on LoopNet and CoStar, investors already know about it and there’s a reason it’s not selling.” Rein finds properties that fit his clients’ criteria and approaches the owners, which might need the influx of capital to pay off other mortgages.

Owners, likewise, might need help uncovering opportunities in their own portfolio. For example, in Charleston, S.C., local families or out-of-state investors who don’t pay attention to the market may not be aware that their neglected historic properties now have value. “If we think it’s time for them to sell, we can match them up with the right buyer,” Morse explains. These owners are usually interested in selling to get the cash, but they aren’t in a position to renovate the property. That means they can sell at a bargain, Morse adds, which is good for the market.

Put a Ring on It

When investors finally find the right property in the right second- or third-tier city, they don’t want to let it go. “Lately, investors seem to be planning on a longer hold period than investors who were buying properties 10 years ago,” Berezin says. “They accept that, while this market is clearly going to support appreciation, this is not an environment where a two- to three-year hold then flip strategy is going to succeed.”

Asset tangibility is also a factor. Baker works with local private investors who like to know the property and the trade area. In other words, they want a property they can literally hold on to. “They’re not thinking in terms of hold periods,” Bakers explains. “Their goal is long-term income — mailbox money.”

Baker recently worked with a private investor who purchased a land lease to a national restaurant chain in a Louisville, Ky., submarket from another private investor at a 7.5 percent cap rate. The buyer could have purchased with all cash but decided to leverage around 50 percent of the cost with a local bank at 4.5 percent to maximize returns on the property and spread the risk around. This also left the buyer with more cash to invest in local real estate.

And when it comes to distressed properties, “fix and flip” is now “fix and hold.”

“Most active investors have a value-add mentality with a long-term investment horizon,” says Darren Powderly, CCIM, president of Compass Commercial Real Estate in Bend, Ore., where cash buyers are looking to capitalize on a flood of available real estate-owned assets. “They feel that purchasing a good property at prices well below replacement cost and then adding value will result in attractive investment returns five to 10 years from today.”

Morse is pursuing this strategy in Charleston. In 2010, he put together an investor group with other brokers to purchase a 3,000-sf historic mixed-use property on King St. from a “cash poor” seller who needed the capital to pay off other mortgages. The group renovated the property and increased occupancy from 50 percent to 100 percent. They plan to hold for five to 10 years and wait for the market to catch up.

Overall, however, there is still enough uncertainty in the market to constrain value-add investments, Slatin says. But he expects more opportunistic money to go after distressed assets this year, and a large portion of those transactions will take place in secondary and tertiary markets.

That said, investors that hold out for bargains risk being left behind. “Prices are low and may go slightly lower, but it’s not worth waiting for the ‘perfect’ opportunity when ‘almost perfect’ ones are available in smaller markets,” says Casey Weiss, CCIM, principal with Access Commercial Real Estate in La Crosse, Wis. “It’s important to buy based on solid fundamentals, not simply a bargain price.”

Good deals in these markets are limited, Weiss adds. If investors aren’t looking now, they might be too late.

Rich Rosfelder is associate editor of Commercial Investment Real Estate.

Wooing Small-Market Investors

As investors venture into secondary and tertiary cities in search of more lucrative opportunities, they’ll need expert assistance to navigate each market’s unique real estate landscape. How can CCIMs set themselves apart and become the go-to resource for potential clients in these markets? Commercial Investment Real Estate asked designees to share their tips for wooing investors.

Network. Many deals involve off-market properties, so it’s important to know which investors have capital and are in “an acquisitive mode,” says Liam Murphy, CCIM, of Hayes Commercial Group in Santa Barbara, Calif. Two partners in Murphy’s office recently approached a local investor with an opportunity to purchase a $10 million property. That investor referred them to an interested party, and they closed the deal.

Pick a niche. “Focus on specific types of properties in a larger geographic area,” says Larry Goldman, CCIM, director of commercial properties with Re/Max Best Associates in Overland Park, Kan. When the downturn hit, Goldman started working on real estate-owned deals in Missouri, Arkansas, and Illinois. “The specific focus, plus a strong Web footprint, positions me well for REO dispositions, buyer rep work, and other profitable assignments,” he adds.

Develop a process. Gregory Fitzgerald, CCIM, of Tri-Oak Consulting Group in Canton, Ga., uses “The Closing Navigator” to meet the needs of net-leased retail property investors and sellers. The process — strategize, locate, qualify, offer, close — relies on transparent collaboration among transaction parties and a strong commitment to the property niche.

Stay involved. Bob Rein, CCIM, associate vice president with NAI REOC in Austin, Texas, is an active member of NAI’s Global Investment Council, which includes the company’s most experienced investment advisers. He also attends courses offered by CCIM Institute’s Ward Center for Real Estate Studies “to keep [his] industry knowledge current and learn new techniques.”

When investors call, call them back. “Returning calls seems like a very basic business practice, but it takes time and is surprisingly uncommon,” says Casey Weiss, CCIM, principal with Access Commercial Real Estate in La Crosse, Wis., who has heard this complaint from several new clients. “By simply staying in touch and following up, I am providing much better service than some competitors.”

And remember: The numbers are on your side. Commercial real estate is currently seeing solid risk-adjusted returns compared with investment alternatives such as stocks and Treasuries, and it doesn’t hurt to remind potential investors. “I typically explain to my clients the benefits of investing in commercial real estate vs. the stock market, and I usually get their attention when I discuss 15 percent to 20 percent IRRs,” says Richard B. Morse, CCIM, of Palmetto Commercial Properties in Charleston, S.C. “I don’t believe there are many investments out there now that generate that type of return consistently.”