Tertiary markets

Minor Markets, Major Gains?

Investors look to secondary and tertiary markets for class A product with higher returns.

By Beth Mattson-Teig |

Communities such as Des Moines, Iowa, Durango, Colo., and many lesser-known cities in between are bursting with commercial real estate investment activity as national buyers turn to small markets in hopes of finding big returns.

In most major metropolitan markets, the seemingly insatiable demand for commercial real estate property is continuing to push sales prices higher. Capitalization rates have dropped between 200 and 300 basis points in the past five years and sales are commanding top dollar. For example, the sale of New York City's 5 Times Square at the end of 2006 was one of six deals last year that broke the $1,000 per square foot mark. The 1.1 million-sf office building sold for a whopping $1.28 billion or $1,168 psf. With prices reaching such record highs in major markets, buyers are widening the search for quality properties that still deliver an attractive yield.

Photo caption: Smaller cities with strong job growth, such as Colorado Springs, Colo., are becoming more attractive to commercial property owners.
Photo credit: J.C. Leacock/CTO

"There is no question that you have to look farther out for investment opportunities today," says Allen C. McDonald, CCIM, a principal at Baker Storey McDonald Properties in Nashville, Tenn. The company owns $75 million in commercial properties throughout the South in cities such as Nashville, Memphis, Tenn., and Louisville, Ky. But as competition for commercial real estate properties has intensified in these cities, the company has targeted secondary and tertiary markets such as Murfreesboro and Columbia, Tenn.

As a result, Baker Storey McDonald has discovered hidden gems such as a former Kmart in Columbia that the company acquired in spring 2005. After completely renovating and leasing space to tenants including T.J. Maxx and Office Depot, the company sold it to a South Florida investment group at a considerable profit. "The building was totally vacant, but we knew it was a strategic asset in a smaller market," McDonald says. "So in this particular case, we knew it was worth the risk to take it down and do the leasing." The 95,000-sf Columbia MarketPlace sold in August 2006 for $12.1 million or a 7.05 percent cap rate.

"In the past, these investors have been staying with where they know and what they know," says James R. Tansey, CCIM, commercial sales associate and investment team leader at NAI Ruhl & Ruhl Commercial Co. in Davenport, Iowa. "But with the higher cap rates available in these smaller markets, people are taking the time to look under some of these stones to find quality properties," he adds.

"Investing in secondary and tertiary markets is at the forefront of consideration for the majority of private investors," agrees Hessam Nadji, managing director of research services at Marcus & Millichap, a national real estate investment brokerage company based in Encino, Calif. Not all investors will follow through with an actual purchase, but they are at least willing to look at opportunities in smaller markets. That is a significant change from even a decade ago when investors were not comfortable buying property that was more than an hour's drive from where they lived, Nadji says.

Part of that growing acceptance is due to the fact that there is much more information available today on properties across the country. Not only are investors able to tap into a wealth of data sources, but the Internet makes that information very accessible. As a result, investors can review a large inventory of available properties with data ranging from floor plans and photos to rent rolls and sales comparables. Those tools make it much easier to conduct property and market analysis than was the case even five years ago, Nadji adds.

The surge in investor interest is good news for CCIMs who specialize in secondary and tertiary markets. Yet brokers eager to capitalize on the heightened demand are faced with the dual challenge of finding suitable investment properties among a more-limited stock and putting their communities on the radar screen for potential buyers.

Photo caption: A former Kmart in Columbia, Tenn., Columbia MarketPlace sold for $12.1 million in August 2006.
Photo credit: Baker Storey mcDonald Properties

Off the Beaten Path
Out-of-state investors always have shown interest in secondary cities such as Omaha, Neb., but cap rate compression has triggered increased attention, says Jim Maenner, CCIM, SIOR, a vice president at CB Richard Ellis/MEGA in Omaha. Investors are looking at class A office properties in Omaha where the yield is 7.5 percent. Even though that yield has dropped 100 to 200 basis points in the last two years, it still is attractive to investors looking at comparable properties in California, Maenner notes.

For example, two of Omaha's top office buildings, One Pacific Place and Valmont Plaza, recently sold to investors from California and Texas at cap rates in the 7 percent to 7.9 percent range. Historically, cap rates on comparable buildings would have been in the 8 percent to 9.9 percent range. However, even at the 7 percent range, investors view the Omaha properties as bargains compared with markets such as California or Washington, D.C., where class A office buildings are selling in the 5 percent to 6 percent cap rate range, Maenner notes.

Iowa's Quad Cities is another market typically dominated by local owners. Yet in the last year dozens of institutional investors have descended on Davenport and its sister cities of Bettendorf, Iowa, and Moline and Rock Island, Ill., in search of investment opportunities. "There is a lot of investment activity in our market," Tansey says. "Retail centers seem to be the most coveted, but good quality, well-leased office and industrial buildings with good credit tenants also are very popular."

Along with higher cap rates, a desire to diversify investment portfolios also is creating demand, Tansey says. He recently represented the seller in the sale of a 15,000-sf retail center in central Illinois to a Michigan-based investor. The property, which is anchored by a Hallmark store, sold in mid-November 2006 at a 9 percent cap rate.

In some cases, investor demand is so strong that it is pushing cap rates to extreme lows even for small markets. "We have seen tremendous demand for the past three years," says Ronald E. Ross, CCIM, a broker at Re/Max Equity Group in Bend, Ore. That overwhelming demand coupled with scarce inventory and fierce competition has pushed cap rates into the 5 percent to 6 percent range - returns that are more typical of a major metro rather than a community of 70,000 people, he adds. Ross recently represented a buyer in the acquisition of Marquis Square, a 12,000-sf retail property in Bend that was fully leased to three tenants. The property sold to a private investor from California for $3.1 million or a 6.1 percent cap rate.

Photo caption: The Columbine Commercial Center in Gunnison, Colo., is being marketed at a 10.5 percent cap rate.
Photo credit: United Country-Timberview Realty LLC

Risk vs. Reward
Such activity in secondary and tertiary markets is on the rise, despite the perception that small cities represent a greater risk. The smaller size often translates into a less-diversified economic base and a shallower tenant pool. But the biggest concern for investors is the risk they are assuming on the exit strategy: Will there be sufficient buyer demand when it comes time to sell?

Whether they are being compensated adequately for that risk is another question investors need to address. For example, Baker Storey McDonald expects to generate a 125- to 150-basis point premium when it acquires properties in small markets. However, in recognition of those risks, the company also has a firm threshold on how small a market it is willing to target. "We wouldn't buy into a market that has a trade area of less than 50,000 people and a five-mile radius of perhaps 35,000 people; that eliminates a whole lot of cities," McDonald says. "As part of any investment, you have to have an exit strategy before you get in. If the market turns bad, your exit strategy becomes almost impossible if you are dealing in a really small city."

Each investor ranging from large institutions to individual private buyers has its own definition when it comes to market size. Yet even towns as small as Durango, which is home to about 15,000 residents, are attracting investors, both from within Colorado as well as buyers from California and New Jersey. "Although, historically, this has been a resort and second-home market, there is definitely a new trend emerging," says Doreen R. Letson, CCIM, owner/broker of United Country-Timberview Realty LLC in Durango. "Many investors from the Denver area are looking for investments in our area because they cannot find the quality or the cap rates in the city."

Letson is working with an investor from Colorado Springs, Colo., who is having trouble finding a replacement property for a 1031 tax-deferred exchange. The investor is widening his search because he is not satisfied with the low cap rates in the Colorado Springs and Denver area that are falling between 5 percent and 7 percent. Despite its small size, the Durango area delivers higher returns that typically fall between 7.5 percent and 10.5 percent depending on the property. For example, Letson currently is marketing the 15,000-sf Columbine Commercial Center in Gunnison for a 10.5 percent cap. The property features commercial tenants on the lower level and residential units on the upper level.

Mitigating Risk
Risks are inherent when buying into smaller markets. Two ways that investors are trying to get comfortable with those risks are by focusing on buying quality properties and conducting thorough market analyses.

In Omaha, for example, buyers are shopping for top properties. "Quality is selling. Investors are not looking at B and C properties or turnaround situations," Maenner says. At one time, investors might have worried about liquidity in a smaller market. But that concern is not so great with the increasing flow of global capital and the presence of national, high-credit tenants in many of these buildings, Maenner adds.

In the case of the $36 million purchase of Omaha's Valmont Plaza, a key selling point was its stellar tenant list. In addition to serving as the headquarters for Valmont Industries, the class A office property is home to high-profile national tenants such as UBS, New York Life, and Wachovia Securities. "The roster of tenants is the same as you would find in other class A buildings in other markets. So investors find some comfort level in having that base of creditworthy tenants," Maenner says.

Another way investors are managing the potential risks of smaller markets is by performing detailed market analyses. "If you do your homework, there are more opportunities. But you have to do your homework and know how to research the market," McDonald says. Baker Storey McDonald, which also operates a retail real estate consulting division, utilizes an extensive checklist regardless of the market size. One technique is to conduct a demand gap analysis for retail properties that compares the target market to other cities similar in size.

Other criteria Baker Storey McDonald looks for are features such as a college or a major medical facility in the community that provides a solid economic base. "We also look at the employment base and type of employment there to judge overall market stability," McDonald says. For example, if an investor is analyzing a market that has a huge manufacturing base, that employment base becomes somewhat suspect due to the shift of manufacturing outside the U.S., he adds.

While major markets tend to resemble each other in demographics and tenant base, in small markets, investors clearly must weigh the unique aspects of each area. For example, one of the big selling points for multifamily and retail investors in the El Paso, Texas, market is the $2.6 billion expansion of Fort Bliss. The military base will increase the troop base by almost 19,000 new soldiers who are expected to bring about 27,000 family members with them to the area. El Paso also takes advantage of its border location next to Ciudad Juarez, Mex., which is home to about 2 million people. "We have found that investors have become increasingly more interested in El Paso and southern New Mexico, which are traditionally tertiary-rated markets," says Brett C. Preston, CCIM, a broker at RJL Real Estate Consultants in El Paso.

Staying Power
One question that arises is whether secondary and tertiary markets will remain an attractive investment option in the long term. Further cap rate compression and rising interest rates could make investments in smaller markets less desirable to many investors as yields shrink.

Investment interest in secondary and tertiary markets has heated up to the point that it is closing the gap on cap rates in primary markets. Five years ago the spread between cap rates in primary compared to secondary markets was roughly 200 to 300 basis points whereas today that gap has narrowed to 50 to 100 basis points in many cases, Nadji notes.

Rising interest rates also could diminish the lure of secondary and tertiary markets. "If interest rates go up 100 to 150 basis points, you have to have rent growth to offset that increase in cost of capital," Nadji says. Historically, primary markets have out-performed smaller markets in terms of vacancy reduction and rent growth. Certainly, there are those smaller markets that do have strong economic drivers, but investors need to take a realistic look at rent growth projections when conducting their investment analyses.

Some investors - primarily institutional investors who have a lower tolerance for risk - are turning their attention back to primary markets. "At the same time, that doesn't mean that investments in those secondary and tertiary markets don't have legs. They absolutely do. They have very good fundamentals and upside," Nadji says. Essentially, what it comes down to is the risk tolerance of the investor. Going forward, investment activity in secondary and tertiary markets will likely be dominated by private, entrepreneurial investors who are more comfortable taking on the risk of a smaller market, he adds.

Overcoming Obstacles
One of the biggest roadblocks to investing in many of these small markets is lack of inventory. "We're seeing money flowing out of Wall Street that is looking to invest in real estate. Unfortunately, we don't have enough investment properties to satisfy the demand," says Stephen Perfit, CCIM, SIOR, president and owner of Upstate Commercial Group in Kingston, N.Y. The company services investors throughout New York's Hudson Valley.

There is a strong demand right now for multifamily properties, as well as triple-net-lease properties and shopping centers, Perfit notes. However, those property types are scarce. As a result, CCIMs need to look farther for opportunities to meet clients' needs. For example, Perfit is working to uncover potential investment opportunities that exist not only in other parts of the state but also in neighboring Connecticut.

In addition, brokers are trying to deliver more creative solutions. "A lot of investors have bought vacant or partially vacant office properties with the future hope that they would be able to fill them," Perfit says. Investors that can buy such properties cheap enough are able to hold them even with a couple of tenants.

"What I've been finding is opportunities for investors in my market to purchase vacant properties and wait for a tenant," agrees Kevin D. Fletcher, CCIM, a broker with Coldwell Banker Millett Realty in Auburn, Maine. Fletcher works exclusively in Maine's Lewiston/Auburn market. Those value-added buyers typically target buildings in the $150,000 to $500,000 range. Investors who buy vacant or partially vacant office or industrial buildings at a discounted rate and are able to carry them until the space is rented can produce a stabilized cap rate of between 11 percent and 13 percent compared to existing well-leased buildings that are selling at cap rates of about 8 percent, Fletcher says.

Expanding Marketing Efforts
Brokers are capitalizing on investor interest by enticing buyers to their communities by whatever means possible - such as listing properties on LoopNet or advertising in the Wall Street Journal. But brokers often find themselves assuming the dual task of not only marketing the individual property but also promoting the overall community.

United Country's Letson contends that the biggest roadblock to attracting investors to Durango is educating them about the attributes of the area. Durango is located in La Plata County, which has a population of 50,000. The county has many of the same resources as a larger city: a solid infrastructure, airport, and higher education - only on a much smaller scale, Letson says. The key is educating investors on those attributes and promoting the community as much as the property, she adds.

One of the top concerns is ensuring the community has a diverse business base. In Colorado, for example, investors are wary of buying property in a community that is fully dedicated to the tourism market, because the tourism market can fluctuate if there is a fire or a bad snow year. Tourism certainly is a key component of the Durango business base, but the economy also has oil and gas interests and education, which provides some added diversity, Letson says.

"Investors are buying into an area, not just a property," Fletcher says. "Ask anyone to invest money anywhere, and they need to feel comfortable in the market and the economic base in that area - not just the specific project."

Photo caption: This fully leased, 12,000-sf retail property in Bend, Ore., sold for $3.1 million or a 6.1 percent cap rate.
Photo credit: Re/Max Equity Group

For example, Fletcher and his investment team at Coldwell Banker are working with the local economic growth council for Maine's Lewiston/Auburn area with efforts such as the "LA: It's Happening Here!" campaign. The campaign, which is online at www.laitshappeninghere.com, promotes the area with a variety of business and community information including data on recent developments and real estate opportunities.

The key to promoting the Lewiston/Auburn market to investors is communicating the region's accelerated economic growth. For example, Lewiston landed a new Wal-Mart distribution center and Best Buy is building a store in Auburn that will open this year, Fletcher adds.

"I think that CCIMs in smaller markets need to promote the market itself as an investment opportunity, not just the properties," Fletcher says. "If you bring the investors into the market and show them the upside, you will get the sales."