Market forecast

Secondary Markets Are Becoming First-Choice Investments

Smart money is looking outside major urban centers for new opportunities.

The commercial investment market is always searching for properties that offer reasonable costs of entry and attractive returns upon exit. For many investors, office properties have long been a staple of asset allocation. They offer good returns throughout most of the real estate cycle, and historical data support rent growth expectations over the long term. The risks may be greater than industrial or smaller retail properties, but the rewards are correspondingly substantial.

Traditionally, larger funds have focused attention on gateway cities around the world. These are typically, but not always, coastal cities or national capitals with large populations and a diverse, often high-paying range of industries. Major companies are often headquartered in gateway cities, providing access to a large, well-educated talent pool. Tokyo, Hong Kong, London, and Paris are examples of global gateway cities. The U.S. has New York, Los Angeles, San Francisco, Boston, and Chicago. For years, these cities have been considered safe bets and the most profitable for office investors.

Recently, investors have placed more bets in secondary markets and, perhaps more surprisingly, in suburban properties in those markets.

Where Are We in the Cycle?

The economy has been expanding for several years, which influences the commercial investment market in a few ways. First, demand for quality product skyrocketed in recent years as rents rose and investors realized value in the commercial investment market, both while holding the assets and upon their exits. As a result, pricing has done what pricing always does: It rises precipitously in response to increasing demand.

Given the length of the current expansion, a second dynamic emerged recently. No one knows for sure what the next year or two will hold, but many investors are beginning to hedge their bets in advance of an economic slowdown. This has created a rush to find high-quality product (e.g., office buildings along with multifamily and industrial properties) that will hold or increase its value in the coming years while providing a reliable revenue stream. The competition for these investment properties is also elevating prices. According to research from Transwestern Commercial Services, average price per square foot for Class AAA office buildings in gateway markets increased 19 percent over the past two years, to an average of $623 per square foot.

Running Out of the Usual Suspects

Many investors are struggling to find enough high-quality assets under these conditions. As a result, many fund managers are apprehensive about spending capital in cities and sectors that may have already peaked in price.

Over the past couple of years, investors have started to consider alternatives. Self-storage facilities, for instance, have grown in popularity due to a reputation for holding value and providing a reliable, consistent source of revenue. Even bundled single-family assets are being purchased and managed by real estate investment trusts in search of steady revenues and healthy returns.

Regarding locations, both U.S.-based and international investors are taking another look at second-tier markets such as Atlanta, Dallas, and Phoenix - thriving Sunbelt cities with strong population and job growth, but without the same level of price appreciation as Boston, San Francisco, or Washington, D.C. Investors see opportunities in these cities for more attractive pricing and, therefore, higher yields, with economies that still offer confidence and a successful exit strategy. 

For example, in 2018, Atlanta's office sector saw a continuing surge in investor interest, with nearly $4 billion in sales, well above the metro area's historical average. (By way of comparison, the figure for Boston was $6.4 billion.) This activity came from a range of buyers and buyer types, both domestic and international, reflecting deep and wide interest in Atlanta. In Dallas, the office sector saw $4.4 billion in office sales during 2018, one of the highest annual figures in that market. The smaller Phoenix area achieved nearly $2.8 billion in sales in 2018, a new annual peak for that market.

Reconsidering the Suburbs

Increasingly, many opportunities for both attractive pricing and higher yields are coming from the suburbs. Looking again at Atlanta's top office sales of 2018, the property types and locations are striking. Unsurprisingly, sales activity in newly constructed towers was strong, but older, renovated properties also commanded strong pricing. Six of the top 10 sales in Atlanta in 2018 occurred outside of the central business district. In Dallas, 90 percent of 2018's office sale volume was in the suburbs, while suburban properties accounted for 85 percent of Phoenix's sale volume. In contrast, 71 percent of Boston's sales volume in 2018 was found in its central business district.

This new interest is due in large part to the urbanization of the suburbs. Neighborhoods that once had traditionally suburban qualities now offer urban amenities, such as entertainment and public transit, which give office users and residents an experience often associated with urban centers - all at price points lower than those in urban centers. These projects become beacons, generating successful leasing results with above-market rates that capture investor attention. 

With prices continuing to skyrocket in New York and Los Angeles, this heightened level of activity in second-tier cities should continue, with suburban assets gaining more attention. New players entering those markets will seek to bring more value to their portfolios. Between the added attention given to urbanized developments in the suburbs and the fact many investors are just beginning to take notice of these properties, well-leased and amenitized suburban office buildings may be where the greatest opportunities will be found for the foreseeable future. 

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