The real estate industry is known for its shorthand captioning of complex topics, often assuming that industry participants share common background knowledge. Since this is not always the case, delving a little further into the geographical jargon of market tiers sheds light on investment trends and value-add opportunities that would have gone overlooked just a decade ago.
How are certain geographies designated into tiers? Many variables contribute to these groupings, including the size of a real estate market (think spread of risk and economic diversity), the historical volume of transactions (speaks to liquidity) and population and local domestic product (addresses work force availability and attraction to businesses). However, these variables should not alone dictate investment decisions. Housing affordability, regional tax status, workforce demographic trends, educational infrastructure and quality of life all contribute to the fundamentals that help define market segmentation.
Let’s put some numbers to these market tiers. Today, the greater U.S. has over 50 MSAs with populations over 1 million and 30 MSAs with populations over 2 million, yet there are only five to seven cities typically designated as core or primary or gateway markets. New York, Boston, San Francisco, Los Angeles and Washington, D.C. always appear on these lists, and sometimes Chicago and Seattle make the cut. The next tier, with a secondary moniker, numbers 15 to 20 cities (e.g., Phoenix, San Diego, Denver), with the remainder defined as tertiary or third tier markets (e.g., Pittsburgh, Salt Lake City, Las Vegas).
We often hear that certain institutions will or won’t invest in a city when it doesn't make their hierarchy ranking. While it is important to rely on research and an investment protocol, this grand standardization model leaves many opportunities untapped in an increasingly fragmented commercial real estate marketplace. Painting markets with a broad brush can lead to redlining that fails to adequately account for growing efficiencies in capital flows (both in the real estate industry and the broader economy), improved transportation/distribution infrastructure and greater workforce mobility. These factors have combined to fuel economic growth in secondary and tertiary markets, creating opportunities that will be missed by those constrained by traditional market segmentation.
An expanded universe of opportunistic buyers and sellers has taken notice, however, and in a big way. Commercial property transaction volume in the secondary and select tertiary markets grew from $2 billion in 2000 to $45 billion at the end of 2017. The potential for increased yield for those investors willing to consider non-gateway investments can be anywhere from 150 to 400 basis points on a levered basis, yet with how much more risk?
Certain risk variables in less liquid markets are immutable, including economic recovery that lags the primary markets, as witnessed in this current cycle, or a more rapid retreat when the going gets rough. This “last to rise, first to fall” phenomenon can create a shorter investment window and require a more precise timing play. Additionally, secondary and tertiary markets sometimes fall prey to industry concentration risks that drive a boom or bust profile, as we’ve seen in the past with Houston, San Jose, Orange County, Calif. and Las Vegas. Given these risks, investments in these secondary markets depend on strong property fundamentals—principally investment basis and durable cash flow—during periods of risk aversion and illiquidity.
We have found tangible value in not competing with the bigger institutions who might exhibit a herd mentality driven by their standardization models, and thus have found solid risk-adjusted returns in markets where sound and sustainable demographic and economic drivers underpin improved property fundamentals.
Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm that focuses on real estate investing through direct acquisition of commercial and multifamily properties in addition to originating and funding debt for third-party owners of real estate.