One of the biggest changes we can expect to see in commercial real estate this year is a not-so-gradual shift of focus from gateway markets to secondary and tertiary markets. The reason? The major U.S. gateway cities like Chicago, San Francisco, Boston, Washington D.C., New York, and Los Angeles are posting record asset prices, making it more challenging for investors to make their yield thresholds.
One of the interesting developments over the last 24 months has been the surge of interest by global investors in smaller markets. According to PWC’s Emerging Trends report, over the past year, global capital investments represented 20 percent of all real estate investments in primary markets. What’s more surprising is offshore investors now represent 10 percent of all secondary market transactions -- up from the cyclical trough of 6 percent.
So, why the interest? Though secondary markets are a greater investment risk due to a multitude of factors (a smaller base of large credit-worthy tenants, less interest from large investors, etc.) they also present more growth and development opportunities than gateway counterparts, making them an attractive area for investors seeking high (even double-digit) yields.
Another reason is that smaller markets are simply more affordable. According to the Real Capital Analytics CPPI, primary market asset pricing returned to its pre-recession peak in early 2014, while secondary markets took nearly two years longer—a great opportunity for investors. This pricing discrepancy remains today -- as of the middle of 2017, primary market pricing is now 1.5 times the previous cycle peak, while secondary markets are at 1.1 times the previous peak. This means there is still room for value creation.
Beyond asset pricing, secondary and tertiary markets have a lower cost of doing business. According to IHS Markit, average costs in secondary markets are 16 percent lower (this is especially acute in real estate and energy costs where the secondary markets are 38 percent and 22 percent lower respectively).
Another reason is job creation (the primary driver of office development). According to NAREIT, “office employment in Gateway cities has lagged secondary cities and other markets, reflecting a temporary lull in specific sectors, for example, financial employment in New York and tech jobs in San Francisco. Office employment in secondary markets like Seattle, Denver, Dallas, and Nashville is rising rapidly, with population growth above the national average, and booming local economies generating strong demand for office space.”