The Second-Tier Market Challenge-- Slim Pickings
Money finally seeps back into secondary and tertiary markets now that prized properties in the 24-hour gateways seem over-priced, except that is to foreign buyers looking to park cash in the U.S. and not willing to entertain investments in unfamiliar places.
But that doesn’t mean secondary markets have a lot to offer for sidelined domestic capital searching for higher yields. Most apartment properties have been picked over and bid up—no bargains there. The quantity is generally thin for high-quality core commercial properties and rent levels tend to grow anemically even in the best of times, especially in places with low barriers to entry where an easily built new office building or strip mall can soften overall tenant demand quickly. If a single major employer downsizes or moves out, an entire market can take a hit. As a result, it’s hard to count on dramatically higher values in any given short-to-medium term investment holding period—you basically must count on buying at high cap rates and securing decent income flow for returns.
Many institutional investors seem caught in indecision about whether to make a move into suburban districts and smaller cities. They know most of the available product is commodity, but they need to put money out, and it’s tempting to chase yield if they can buy at an 8.5 or far preferably a 9 or 10 cap rate (compared to sub 6 in the gateways). But if buying activity increases and prices edge up, purchasing at lower cap rates makes for more problematic outcomes, especially if the economy continues to generate jobs at its consistently sluggish pace. And any rise in interest rates, as we have discussed in previous blogs, could be particularly damaging for such investments given the difficulty on banking on any spike in tenant demand and property revenues.
Since most large institutional investment managers long ago closed offices and concentrated “field” personnel in only a handful of regional locations—usually major 24-hour markets, they typically do not have the on-the-ground knowledge or tenant relationships in mid-tier and smaller cities to gain an appreciable investment edge. The players positioned to master these markets are really the local operators, often family developers or old line firms with deep “home-town” roots. They have been willing to invest in their communities, hold for the long-term, and get rich slowly, husbanding tenants and cash flows.
It follows that if institutional players have a chance at success in these markets they will need to joint venture with local operators, and may seek development opportunities to have any chance at attaining the higher yields they covet. If they use advisor intermediaries, these investors will need to be able to judge the capabilities and track records of the local operators these advisors will inevitably employ, and be sure their interests are aligned adequately.
Without strong local connections, these markets could turn into fools’ errands for investors, and even then it may be hard to realize solid returns. If capital starts to pour into these places, it will be time to retreat or cash out quickly unless you are committed to a long slog.