October 31, 2018 Comments Off on The Deep Dive into Smaller Markets Views: 901 Connect Apartments

The Deep Dive into Smaller Markets

Multifamily has been the darling of the investment community, with assets in primary, or “gateway” markets attracting their share of interest and capital. This is because “primary markets consist of core investment capital chasing a safe bet,” commented Will Mathews with Colliers International.

There are, however, only a handful of gateway metros. And, within those markets, buyers are fiercely competitive, often meaning higher prices, compressed cap rates, and lower yield. This, in turn, is creating greater scrutiny of, and investment in, secondary and tertiary markets.

When it comes to multifamily investments, smaller markets tend to be more volatile, with lower barriers to entry and more risk. Yet, more multifamily investors are willing to accept that risk for greater rewards.

Primary . . . Secondary . . . Tertiary . . .

What, exactly, are primary, secondary and tertiary markets? The answer? It depends.

Most experts understand that cities such as Los Angeles, New York, Chicago and Washington D.C. are considered primary markets. They are typically characterized by higher populations and employment centers. With this definition, Dallas-Fort Worth, Houston and Boston would also be considered primary markets.

Definitions aren’t so clear-cut when it comes to secondary and tertiary markets. These markets are typically defined by population count, with secondary markets containing two million to five million people, and tertiary markets boasting less than two million people.

But, designating a market on population alone can create problems. “Detroit has a population of more than five million, but it’s considered a secondary market because investment activity there is on the low side,” said Marcus & Millichap’s William E. Hughes. Then, there is Austin, TX, a metro with just over two million people, which would, on the surface, classify it as a secondary market. However: “the investment activity there is . . . more emblematic of a larger primary market,” Hughes commented.

In determining investor markets, CBRE relies on a “tier” system, ranking metros based on historical property investments and real estate inventory, along with population and economic size. With this in mind, “Tier II” markets might include Atlanta, Denver, Minneapolis, Philadelphia and Seattle. Tier III, in the meantime, could consist of Salt Lake City, Kansas City, KS, and Columbus, OH.

Secondary Markets, Primary Yield

Mike Katz, senior vice president in PNC Real Estate’s Agency Finance business, is active within secondary and tertiary markets surrounding Midwest gateway cities; these markets can typically extend as far as 30 to 50 miles outside the core. “Experienced investors local to these markets have found significant success with both value-add and new construction, due to the sheer lack of new development in more than 20 years,” he said.

On the value-add side, investors that have acquired and updated 20- to 25-year-old Class A or B properties generally have done well over the past several years, Katz noted. Common area improvements typically include modern amenities such as new clubhouses with updated fitness centers, event and gathering spaces with free Wi-Fi, entertainment and business centers, interior modernizations like updated kitchens and baths with granite countertops, updated fixtures and faux wood floors, along with in-unit washers and dryers.

In the area of new development, land costs can be less expensive in secondary and tertiary markets. This, in turn, can lead to more affordable rents, compared to properties that might be closer to metro cores. Some of the most successful of these rental communities, both value-add and new construction, tend to be close to transportation hubs and regional medical, retail and employment centers.

But what about financing? Conventional wisdom dictates that it could be difficult to secure equity or debt in secondary or tertiary markets, because of volatility and more risk. But Katz indicated this isn’t necessarily the case.

“Well-capitalized and experienced local developers have found local banks eager to lend on new projects,” he said. In addition, government-sponsored agencies such as Fannie Mae and Freddie Mac are willing to offer favorable terms for new and value-add properties, given their relative affordability and workforce-housing nature, “as long as the sponsor is experienced in the sub-market and maintains equity in the properties post-refinance,” Katz added.

Risk? Or Reward?

There is a reason why KBS said that “secondary markets may be considered a bit of a riskier investment, but they are increasingly being recognized as more of a ‘calculated risk.’”

Multifamily investors, weary of low cap rates and high prices, could find the better yield and NOI of a secondary or tertiary market property to be a better fit for their portfolios and bottom lines, despite volatility.

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