A Game of Risk
Will investors play ball in secondary and tertiary markets?
By Malcolm Davies |
Every real estate professional is well aware that commercial real
estate is making a comeback. Even during the depth of the recession, the market
of 2009 presented a great deal of opportunity for investors and lenders. Many
of those who took advantage of the chance to buy properties at low prices are
now cashing in on these investments.
But where can investors and lenders achieve that kind of success
in today’s market?
While the caliber of reward achieved by investments in today’s
market may not be as large as it was in 2009, the opportunity for profit still
exists. Lenders and investors are finding a whole new ball game in the
secondary and tertiary markets, turning profits that often beat out their
primary market comparables. As primary and gateway markets have become
saturated with competition, savvy investors are taking advantage of record low
interest rates and are searching for new investment opportunities.
Overall, deals are becoming much more common
and profitable for investors and lenders alike. If these real estate players
are willing to look outside the safe primary markets and take a bit of a risk,
there is a very successful game in which to play.
Primary Market Expansion
To understand secondary markets, it is important to first
understand primary or gateway markets. In the past, if a lender or equity
investor was asked what he or she would consider a primary or gateway market,
the answer would likely be six or seven metropolitan statistical areas: Los
Angeles, San Francisco, New York, Chicago, Washington, D.C., Boston, and
For some, it may seem strange to think cities like Seattle and
Houston would not be considered gateway cities. However, these cities fall
under a relatively new understanding within the industry. As the economy
continues to make a comeback, former secondary cities will now increasingly
become major players.
As a result, today’s perception of what is considered the primary
market is changing. The list of primary market cities now includes former
secondary markets such as Seattle, Houston, Atlanta, Denver, and Charlotte,
Today’s Secondary Market
Beyond the traditional idea of secondary markets, there now exists
a subcategory of secondary markets located within the primary markets. For
example, in the Greater Los Angeles market, it’s pretty safe to say that when
attracting investment and lending capital, the expected yield on an investment
in the Inland Empire would need to be significantly higher than one in Santa
Monica to achieve financing. However, in today’s market, the gap between the
yields has significantly diminished.
For example, in order for investors to stay in safe primary
markets, they must be willing to accept a 4 percent capitalization rate
acquisition in Santa Monica, while a similar asset trades at a 6 percent cap
rate in the Inland Empire.
Investors must also take into account whether the lender will be
willing to go as high on the leverage or low on the pricing in a secondary
market as it would in a primary market. Despite the return, a lender’s perceived
risk will always be higher if the attraction of the investment’s location is
For cash flow investors, there is an additional caveat. There will
be a point at which these investors will not be willing to invest in primary
markets simply because the minimum yield return will be below the threshold for
accepting the risk of owning real estate. This can be the same for a lender.
However, the one thing we’ve all learned over the past few years is that there
is always risk involved when owning, or lending on, an illiquid asset. The real
question is whether everyone is willing to accept a sub-4 percent cap return to
stay in the primary markets.
As structured finance capital advisers, we have seen that many
investors and lenders are willing to take the risk of investing in a secondary
market to score a bigger return. In 2012, we were able to help our clients
capture market share in secondary market regions that had previously been slow
to recover from the recession, such as San Bernardino County, Riverside County,
and Sacramento, Calif.; Phoenix; and Portland, Ore. We were also able to
capture the attention of lenders and investors who were willing to leave the
gateway cities to acquire properties that generated 5 percent to 10 percent
higher internal rates of return than similar properties in the primary markets.
Additionally, pricing for our lenders exceeded what they would be able to
charge in the primary markets, making these secondary market investments
profitable for both investors and lenders alike.
The Deciding Factor
Lenders and investors have learned a valuable lesson from the
recession: Gateway markets have a much better retention of employment during
economic downturns than secondary and tertiary markets. Both lenders and
investors are asking key questions about job growth in smaller markets and
whether or not companies are moving to these areas. These questions are
critical to today’s lender/investor thought process, as lenders want to feel
that employment rates are increasing or at least stabilizing before they will
Regardless of asset class, investment groups and lenders are
putting their focus where they can make a profit, which is in secondary
markets. Both entities want to see the potential growth of these secondary
markets play into the cap rate arbitrage for the loan, and hope to see better
pricing than they would have in the primary markets, all without too much
Our structured finance team has been very active over the past 12
months in many of the secondary markets that are now making a comeback. We have
seen investors and lenders take advantage of returns on cost that are now
higher in these markets than they are in coastal Southern California markets.
Even construction financing is now available in these markets, and we are
seeing these construction lenders requiring healthier debt yield returns for
The Final Frontier
Tertiary markets such as Reno, Nev., or Albuquerque, N.M., have
less job growth historically, and, in turn, are the last of the markets to see
a recovery. Therefore, tertiary markets are also the last to see cap rate
compression or the loosening of lending standards, which slows investment
opportunities in these regions.
Despite the sluggish recovery of these markets, financing is definitely
available for savvy investors. As in the secondary markets, however, lenders
are charging a premium for this financing and the equity investor is getting a
greater return due to the location of the asset. All in all, lenders and
investors look at tertiary markets in the same way: They want a greater return
on their investment due to the greater risk and lack of depth in the market.
The majority of investors in these markets are long-term holders of such real
When we finally do see cap rate compression in these third-tier
cities, we will see the full recovery of the commercial real estate market as a
whole. Traditionally, the tertiary market is the last into the upturn and the
first into the downturn.
If commercial real estate were a baseball game, then the primary
and gateway markets are in their third or fourth innings, the secondary market
is in the first, and tertiary is in the dugout, en route to the batter’s box.
Invest wisely, and know that at the very least in 2013, all signs for all asset
classes are pointing up, increasing the chances of a few grand slams in a
variety of markets this year.
Malcolm Davies is
senior vice president of George Smith Partners, a real estate investment
banking firm headquartered in Los Angeles. Contact him at