The Secondary City Conundrum

The bifurcation of lending and investing between the major cities and the rest of America continues. Lenders continue to strongly favor primary cities and large secondary markets, but still shun smaller locations. Funds continue to tell their investor base that they will not do deals in secondary cities. Foreign money favors major cities on the coasts. The result is almost all of the money is focused on a small number of deals and the prices get bid up to where they no longer make good sense in most cases. Cap rates in Manhattan, Washington, San Francisco and a few other major cities have gone too low and are not justified, especially with the high probability that the economy will be a disappointment for quite awhile and there is no magic bullet to drive occupancies other than in multifamily. Lenders ignore the secondary cities for reasons that do not make sense.

There are many good secondary cities around the country and they have their own local demand drivers that are not necessarily tied to the macro issues in the same symbiotic way that New York and other major cities are. While these locations did not and will not experience the hyper pricing that New York and San Francisco do, they also have more protection from huge declines. There are hospital centers, prisons, concentrations of certain manufacturing or mining that may slow down, but at this point are not likely to experience the sort of drastic drops we saw in 2009 -20010. For a lender to reject a good cash flowing asset for a loan when the debt yield is at or above the minimum underwriting criteria, just because it is a secondary or even tertiary city, makes no sense. At worst the debt yield may drop 2% or so, but it is not going to zero even if there is a new recession. Leverage now is far more rational and conservative, and debt yield is the driver of the underwriting, unlike in 2007 when only bonuses drove underwriting. To not make a loan which is well underwritten today, for a good sponsor, with a good asset, is nonsense. If the asset is providing sufficient debt yield today, it will most probably provide an even better debt yield in 3-5 years when the economy will likely be better. If the loan underwrites today, there will be a refinancing lender to repay you in 3-5 years at maturity. If nothing else a local or regional bank will do it even if CMBS is dead. By then there will be several years of good cash flow on which to make a loan. If the deal is carefully underwritten by today standards and today values, then for it to go bad in a secondary city means we have far bigger issues than is it a secondary city. The bottom, or near bottom of a cycle is when to make loans, and that is where we are today. Far better to make loans now than in 2005-2007.

For equity investors, it is rational for a NYC private equity fund to not do a one off $5 million dollar deal in a small city. It is not worth the effort. But to not do a portfolio of substantial size makes no sense if the assets are good and the secondary cities each have a good local demand driver that will continue to exist for many years, like a big military base, or several factories or other facilities of one or more major companies. A portfolio of good assets, well underwritten, and not over levered, is likely far safer today than a single very large asset in a major city. Maybe it does not look as nice on the cover of your next offering memo, but steadily increasing double digit current cash flow is a nice thing to show investors. I will take good current returns from a portfolio of good assets in secondary cities with a lesser pop at terminal value, than hoping to turn around a single large asset trying to get one big hit. Maybe that is an old guy talking who has seen too many bets on the big hit that did not work. Steady cash on cash, growing nicely as the economy improves over several years is my idea of good solid investing. If you believe we may be at or near the bottom of the cycle, then investing in solid assets in secondary cities makes good sense as cash flow will grow over the life cycle of the investment.