Tertiary markets Second-tier markets

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 Dallas.

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, N.C.

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 lower.

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 invest.

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 additional risk.

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 their safety.

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 estate.

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 mdavies@gspartners.com.