Apartment investors are jumping at the chance to buy property in Manhattan, Kansas, that is, at 6 percent cap rates. Buyers who used to dismiss such tertiary markets as “flyover country” are now stopping to take a second look.
Capital is also expanding into smaller cities, chasing better yields and growth opportunities in secondary markets. According to Real Capital Analytics (RCA), investment sales volume in tertiary markets increased to $147.0 billion in 2021. Although tertiary markets account for a small percentage of the total sales market, about 18 percent, sales volume increased by 56 percent over the past year. $94.2 billion in sales transactions recorded in 2019. (RCA defines tertiary markets as those outside the top 40 MSA it tracks as major and secondary metros.)
Investors can’t always agree on a precise definition of a tertiary market, but there is increasing interest in opportunities beyond the top 30 or 40 MSA in smaller metros including Columbus, Ohio, Jacksonville, Fla., Louisville, Ky. Omaha, Neb., and Boulder, Colo., others. The biggest motivator is yield, with cap rates falling below 4 per cent for most sought-after properties, especially in gateway and secondary cities.
“We are in a low-yield environment and people are reaching for the yield. So, if you can get a higher cap rate in some of these tertiary markets, that is very attractive to investors,” said a senior at Costar Group. Consultant Joseph Biasi says. “The only trick with a tertiary market is that people are very little familiar with them, and it’s very hard to get foreign dollars there,” he says. Lending volumes, generally outside the top 25 metros, were up 10 per cent from 2019 levels, compared to a 14 per cent increase in secondary markets and 18 per cent decline in primary markets.
Tyler Hague, a senior vice president at Colliers International’s Chicago office, notes that competition for property in Sun Belt states such as Florida, Texas and the Carolinas is driving cap rates up to almost ridiculously low levels. Hague is the head of the firm’s Midwest Multifamily Investment Sales Group. “Because of that, buyers who would never have been to secondary markets in the Midwest, let alone tertiary locations, are starting to explore those opportunities,” he says.
The Hague’s team is currently selling multi-family properties in metros such as Columbus, Louisville, Ames, Iowa and Manhattan, Kan., where the team has sold more than 1,000 units in the past year. The Hague notes that investors buying apartments in tertiary markets are typically getting discounts of 50 to 100 basis points compared to similar quality properties in larger metros. For example, an apartment in Manhattan, Kan., that sells for 6 percent will go to nearby Kansas City for 4.75 percent, he says.
looking for produce
When it comes to moving to tertiary markets, net lease investors have been ahead of the curve, primarily because the properties they’re buying are backed by credit tenants with long-term leases, such as Walgreens, AutoZone and Taco Bell. , which reduce investment risk. , However, these days the pool of buyers is bigger with interest from investors ranging from high-net-worth individuals and family offices to REITs and private equity funds. One of the drivers for this is simple supply and demand. Matthew Mousavi, managing principal of National Net Lease Group at SRS, says too few deals have more capital behind them, which is prompting investors to increase their searches.
SRS recently sold a pure leased Home Depot distribution center in Salem, Ore., for $50 million at a cap rate of approximately 5 percent. The deal attracted interest from both private buyers and institutions across the country. The winning bidder was a high-net-worth investor, which also reflects changes in the bidding pool, Mousavi says. “Twenty years ago, that property was sold to an institution, a pension fund or a life insurance company. Now we have private individuals buying net lease deals of $50 million in tertiary markets,” he says.
Technology and greater transparency have also made it easier to buy property in smaller towns. An investor in New York who is interested in a property in Ohio can use Google Maps’ Street View option to view that site on their phone or tablet, and they can easily pull up market and sales comp information. . “It’s a very different technology to our business that makes those markets more efficient and brings in more capital,” says Mousavi. Real estate is still a viable business and people need to look at physical assets, but it is easier than ever to assess a property remotely, he adds.
worth the risk?
Traditionally, large institutional investors have been wary of the challenge of being able to capitalize on a large scale along with greater risk and less liquidity in smaller metros. However, many smaller metros are registering strong growth, which has been further boosted by the pandemic and remote working.
According to NAIOP’s research brief, How the Other Half Builds: Small-Scale Development in Tertiary MarketsTertiary markets are home to nearly half of the US population and represent a significant portion of the commercial real estate market. Briefly mentioned that high exit risk may discourage developers with short time horizon from entering tertiary market, higher yield and less competition favoring longer duration in smaller markets.
“Investors are attracted to very attractive returns and sound fundamentals that are delivering strong long-term returns in tertiary markets. Additionally, strong job growth and continued migration from gateway markets is contributing to the growth of secondary and tertiary markets,” says Matthew Lawton, executive managing director and leader of investment sales and advisory platforms at JLL Capital Markets. However, investors are very selective and not only portraying these markets and sub-markets with a broad brush. They say they are implementing strategies similar to those employed in primary markets, such as looking at employment centers and demand drivers such as tech, STEM, “AIDS and MED” and state capitals.
One question is whether investors are getting adequately compensated for the risk. “I am surprised to see some of the yield investors are accepting in tertiary markets,” says Mousavi. Investors chasing yields have no choice but to move to tertiary markets. However, there are also investors who have looked at tertiary sectors who do not feel that the returns justify the risk and prefer to buy assets in the top MSA at a 3 or 4 per cent cap rate rather than accept 5 per cent or 6 per cent . Cap rates in a smaller city with a higher risk, he says.
In addition, the cap rate spread between top markets and tertiary markets is shrinking. According to CoStar, asset valuations in both secondary and tertiary markets are up 26 percent and 22 percent, respectively, over 2019 levels in 2021. Cap rates have also come down significantly. In Multifamily, for example, the spread in average cap rates between secondary and tertiary markets has decreased by 30 basis points, according to Costar. “The cap rates have actually been pushed down as demand picks up,” says Biasi.
Mousavi notes that cap rates on net leased assets in the top 25 MSAs used to be 5 percent, compared to 8% or higher. These days net leased property in tertiary markets can be priced at a cap rate of 5.5 or 6 percent, as compared to 4 or 4.5 percent for the top tier market. The returns aren’t as good, but investors are still looking to tertiary sectors for that higher yield, he says.
