Tertiary markets

Tertiary Markets

Investors explore various opportunities in search of higher ROI.

Mirroring national trends, commercial real estate professionals in diverse local U.S. markets are experiencing strong interest, especially from out-of-state investors. Their biggest problem isn't demand, it's supply. 

“The biggest challenge is having the supply of ready-and-willing sellers for properties that investors want to buy,” says Erik Olson, CCIM, vice president of investments properties and multifamily at CBRE in Albuquerque, N.M.

Tucked into the Southwest, Olson usually counts on a steady growth market in New Mexico that does not have the drastic highs and lows of larger U.S. cities. This year, however, deals in the New Mexico cities of Albuquerque, Santa Fe, and Las Cruces are cresting 68 percent higher than in 2014.

Based in Lexington, Ky., Bruce Isaac, CCIM, SIOR, senior vice president at NAI Isaac, has experienced a 20 percent increase in commercial real estate transactions compared to 2014. Out-of-state investors are coming to this well-heeled tertiary market for better returns because primary market capitalization rates are so aggressive, according to Isaac.

Poised on the outskirts of greater Philadelphia, Craig Fernsler, CCIM, vice president of investment services at KW Commercial in Blue Bell, Pa., has seen higher numbers of transactions compared to 2014. He has experienced the most growth in transactions involving Internal Revenue Code Section 1031 exchanges.

While tertiary markets such as these don't often offer the scale that large institutional investors seek, they do offer the diversification of product, market, and investment style that is increasingly becoming the hallmark of a strong real estate portfolio, regardless of its size.

Overall, tertiary markets excel in value-add opportunities, providing investors with strong returns in exchange for improving commercial real estate properties. Investors who seek fairly safe investments with a hold length of at least three years can often see a significant return on investment. When a market adjustment comes, tertiary markets often lag behind primary markets by a year or two and sometimes weather the storms better by being less volatile.

Investors Seek ROI

Known as the horse capital of the world, Lexington is Kentucky's second-largest city with a metropolitan statistical area of 600,000 people. The money spent in Lexington would support a typical population of 800,000, making it attractive for investments, according to Isaac.

He is working with investors of all stripes - local, out-of-town, out-of-state, private, and institutional. Many of the local investors are using 1031 exchanges to delay paying taxes and upgrade their investment property. Reflecting the national trend, investors are gravitating toward retail, industrial, office, and urban properties.

“Investors in Lexington are buying properties that provide a stable income or value-add opportunities,” Isaac says. “Overall, our city has a good balance of development and growth, seeking to retain its unusual characteristics, such as the more than 450 horse farms.”

In the New Mexico markets, about 60 percent of the investors are from out of state, primarily from California and the Pacific Northwest. “In those markets, if you sell at a 4 percent cap rate, you'll have to buy at the same cap rate if you stay in the same market,” Olson says. “So investors are branching out to tertiary markets such as New Mexico to achieve higher cap rates, higher cash flows, and higher returns.”

Olson works primarily with private owners, high net worth individuals, and small private syndications that invest in properties valued between $1 million to $10 million. Most of these private individuals are not part of large acquisition companies and many work in other professions, relying on Olson to provide good investment advice on local properties throughout New Mexico.

Likewise in Pennsylvania, Fernsler has more investors coming from outside his market to gain a better ROI. For example, three sons in their 60s from New York City have created a family trust in their father's name to invest in single- or multitenant retail properties to provide wealth generation for their children.

After holding properties for 20 to 25 years, several of his clients want to sell their management-intensive rental properties and move into a relatively stable, long-term net-lease property, such as a CVS or McDonald's. “They are using 1031 exchanges to move from one asset class to another while deferring taxes,” says Fernsler.

Improvements Spur Growth

Isaac works in retail, land, and industrial markets with large companies such as Walmart. “The larger transactions are very demanding, complicated, and take longer to close,” he says. His problems have included finding Native American burial grounds in a development project where Isaac had to consult with archaeologists, relocating an endangered species off-site before breaking ground, and investigating underground mines that caused a property to sink.

Currently, Isaac is working on the sale of a $20 million, 400,000-square-foot mixed-use development of office, retail, and warehouse space to a local-national partnership that understands the Lexington market. NAI Isaac was initially hired by the Fortune 500 lender that took back the property. The current property owner - a $100 billion private equity firm - also hired Isaac to lease and manage the property.

In Albuquerque, the buzz words for investment properties are “value-add,” meaning properties that are in a good location and older or in a secondary location but newer, according to Olson. “My clients are looking for ways to force-appreciate properties by renovating interiors, improving facades and pools, and upgrading landscaping,” he says.

Olson says investors are bringing Albuquerque properties up to 21st-century standards and then raising rents and managing properties better through third-party management companies. For example, he sold a 130-unit apartment complex in April 2015 for $7 million to a small investment company from California.

The property was in a distressed condition and only 60 percent occupied. The new owner obtained a multi-million dollar acquisition and construction loan and is in the process of renovating the units. The plan is to sell in three years.

In Pennsylvania, investors are looking to commercial real estate to provide diversification from such options as a volatile stock market and banks that offer little interest on savings, according to Fernsler. “Real estate is a good way to grow wealth when compared to the stock market,” he says, especially through the use of 1031 exchanges. “The 1031 exchange allows clients to invest the capital from the sale while deferring taxes. In the stock market, an investor cannot sell shares, buy different shares, and defer taxes.”

Looking ahead, Olson is seeing higher yields for investors in secondary and tertiary markets and compares the time frame in Albuquerque to the third or fourth inning in a baseball game before the next market correction occurs.

During the Great Recession in New Mexico, new apartment construction was at a standstill for more than four years. With the population growing and the demographic changes of millennials who favor renting over buying, Olson sees continued multifamily strength due to pent-up demand, strong fundamentals, and ease of lending. “Apartments will be a shining light in the investment world for several more years,” he says.

Other market forces will be coming in next few years that will affect commercial real estate locally, regionally, and nationally.

“Nationally, many CMBS loans will be due in 2016 and 2017, from the 10-year loans taken in the hot real estate market of 2006 and 2007. This will offer us challenges and opportunities,” Olson says. “Owners will either choose to sell or refinance these assets, which mean our brokerage and debt professionals will be very busy helping our clients with their decisions for next three to four years.”


Diversification Key to Institutional Investments

TIAA-CREF Global Real Estate, the nation’s largest manager of U.S. institutional tax exempt real estate assets, oversees nearly $90 billion in assets, according to its managing director, James “Jay” Martha, CCIM. He is keenly attuned to the evolution of the real estate cycle and its implications for total return expectations.

Examining performance over the recent recovery and considering the last six consecutive years of double-digit total returns in commercial real estate, it is clear that capitalization rate compression played a dominant role in total return performance.

“Strong total returns and rising property values have resulted in lower yields. Today’s cap rate spreads over 10-year Treasuries, however, suggest current pricing is reasonable and it may offer the potential for further gains,” Martha says. “Vacancy rates are at or below their long-term historical averages across the four major property types, and construction is subdued except for apartments, which are absorbing the new stock handily.”

Going forward, Martha expects net operating income growth will become the primary driver of performance, and new construction will be a key determinant of future NOI growth. “Our ‘house view’ is that there is likely limited potential for further cap rate compression,” he adds.

While Martha focuses on U.S. multifamily and student housing investments, he says that diversification is key to TIAA-CREF’s ability to meet the needs of institutional clients.

“The common thread to our investment philosophy is the focus on high demand, lower supply markets over the long term, and we have deep exposure in each of these. In addition to investing across property sectors, we invest across investment styles: core, value-added, and opportunistic. Investing across styles of real estate as well as sectors really works to the advantage of our institutional investors.”    

TIAA-CREF also is expanding globally yet recognizes the importance of offering local expertise, he says. Investors are looking for investment opportunities with country and regional geographic and economic diversification, but “Real estate remains a local business. Identifying companies with both global capabilities and local expertise is becoming extremely important to clients,” he says.

Martha obtained his CCIM designation in 1998 to ensure a sound foundation of skills. “I recommend and support my team’s participation in the educational offerings of the Institute. The designation itself sends the message that the individuals in that network are experienced, practiced, and professional.”

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Sara S. Patterson

Sara S. Patterson is former executive editor of Commercial Investment Real Estate.

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