Multifamily investors are finding lower prices and higher yields in secondary markets. “Markets that people gave up on are now markets that people are going back to,” says Walter Page, director of research for Property and Portfolio Research, a division of the CoStar Group. “In most primary markets the average price per sq.ft. is twice what it is secondary markets.”
CoStar now expects to see the lowest average returns on real estate investments in prime markets like New York City and Washington, D.C. The highest average returns will come from investments in secondary markets, including the East Bay near San Francisco; Raleigh, N.C.; Portland, Ore. and Austin, Texas, says Page.
Before the crash, investors didn’t get much of a boost to yield from buying properties in smaller markets. Cap rates for apartment properties in tertiary markets averaged about 7 percent in 2007, just a little higher than the average 6.5 percent cap rates in secondary markets and 6 percent cap rates in primary markets, according to John Sebree, vice president and national director of the national multi-housing group for Marcus & Millichap.
During the uncertain recovery, the cap rate gap between primary and secondary markets widened to 300 basis points as investors crowded into a few safe, core areas. Now more investors are venturing back into secondary markets. “Over the next couple of years that will compress,” Sebree says.
Finding the best secondary markets
A promising secondary or tertiary market doesn’t have to be far from a primary market where investors are bidding up property prices. “You can look in the metro area around a primary market. There will be second and third class neighborhoods where there will be upside,” says Sebree.
For example, the East Bay area of California has a lot of upside potential: apartment rents are 40 percent lower than in San Francisco and 37 percent lower than in San Jose. The East Bay area benefits from the booming technology industry and a strong job market. With an apartment vacancy rate of just 4.1 percent, CoStar anticipates 3.7 percent in average rent growth this year. The office market in the East Bay is also improving, with vacancies at 10 percent and anticipated 16 percent rent growth, according to CoStar.
The market for office space in Orange County, Calif., near John Wayne Airport, is also turning in a positive direction: the vacancy rate there peaked at 19 percent and is now down to 13.3 percent, according to CoStar. “It’s likely to fall to 10 percent,” says Page. However, the recovery in Orange County office space has taken longer than some investors anticipated. “Some jumped in thinking it would be an early recovery—it’s a late recovery,” says Page. “It is possible to miss.”
Atlanta’s job growth, at 2.4 percent, is well over the national average, and is now helping to heal the city’s real estate market. “Atlanta was hammered in the housing recessions,” says Page. However, it’s important to pick the right submarket in Atlanta. “The construction pipeline has already started up in Buckhead and Midtown,” says Page. He expects to see new investment spread to areas further out, like Alpharetta.
Strong job growth is the hallmark of a strong secondary market. For example, Houston has benefited from the growing energy boom. “Houston has been a hotbed for international capital for a while,” says Steve Collins, international director for Jones Lang LaSalle’s capital markets group.Global investors spent $1.4 billion in Houston in 2012 and have closed several landmark transactions already this year.
“We expect that pace to continue as the city provides higher returns as investors move up the risk curve,” says Collins.