Pricing of core real estate investments in U.S. gateway markets has substantially increased due to the significant amount of capital in the global financial system as well as limited investment opportunities that provide the same degree of safety and return as real estate. The amount of capital within these gateway markets (Boston; New York City; Washington, D.C.; Los Angeles; San Francisco; and Chicago) has resulted in a fiercely competitive environment that has driven transaction capitalization rates in major markets to new lows, with the pricing of some assets exceeding replacement cost—an oft-cited relationship that represents the relative frothiness of a market.
This competition has caused a meaningful segment of the investor universe to consider secondary markets such as Nashville, Tennessee; Salt Lake City; and Charlotte, North Carolina, with the hope of obtaining total returns similar to those achievable in gateway markets, but with a higher percentage of the property’s internal rate of return (IRR) being driven by income versus growth. The economic recovery in these smaller markets has trailed that witnessed in gateway markets, but as a number of top secondary markets recover, investors are looking to acquire the best assets there.
Secondary markets tend to behave differently than their gateway peers. While understanding the relative risk and reward of a secondary-market investment strategy is fundamental to prudent investing, many believe that the decision to invest is less of a yes-or-no question and more about understanding the role of a secondary-market strategy within a diversified real estate portfolio.
To best understand the motivation behind investing in secondary markets, it is necessary to discuss the fundamental concepts of yield, growth, and return. A property’s yield refers to annual income (net operating income divided by investment basis) and cash yields (net cash flow divided by investment basis), which represent the amount of cash flow produced by the property. Growth relates to the increase in an investment’s net operating income (NOI) over time, which is driven by rental growth. Return relates to the IRR on an investment, which is also known as the total return. The IRR compares a property’s purchase price with the projected cash flows over the anticipated holding period and represents a true annual rate of return on the investment that is driven by a combination of cash flow and NOI growth.
Consider the Rewards
The most frequently cited rationale to invest in secondary markets is that income and cash yields tend to be higher than those generated by similar assets in gateway markets. When capitalization rates in secondary markets are higher, there are usually 100 to 125 basis points of additional yield over that generated by similar properties in gateway markets. These outsized yields tend to be viewed as less volatile and produce a more durable income stream, which is of particular interest to investors.
In theory, increased cash flow yields also allow investors to acquire assets that produce a higher percentage of the investment’s total return through cash flow versus an over-reliance on NOI growth. In a typical gateway core investment, approximately 65 percent of the property’s total return is derived from income and 35 percent is derived from NOI growth. However, investors are establishing income-oriented funds to acquire assets in secondary markets that produce nearly 90 percent of the total return in cash flow and 10 percent from NOI growth. This illustrates a lower risk profile given that cash flow is tied to contractually based leases, and the investment is not as dependent upon NOI growth to achieve the desired total return. Many investors believe the total returns between gateway and secondary markets are effectively equivalent, thus the overall risk profile is lower due to a larger percentage of the total return coming from cash flow.
Weigh the Risks
Significant risks are associated with investment in secondary markets, with a primary risk being the adequacy of the income yield spread over income yields for similar assets in gateway markets. A substantial spread is necessary given that NOI growth in secondary markets is typically less than that in gateway markets, requiring the higher income yield to compensate investors for lower NOI growth. On average, secondary markets experience lower NOI growth since they do not possess the same economic growth engines of the larger gateway markets. Unless the spread is significant enough to compensate for the more limited NOI growth, investors could achieve underwhelming total returns that fail to meet those observed in gateway markets. As capital continues to flow to opportunities, there also is a concern that the higher yields of secondary markets could begin to compress as competition for product increases.
A risk related to the secondary-market strategy is the fear of a rising-interest-rate environment coupled with lower anticipated NOI growth. Rising rates would cause capitalization rates to increase, putting downward pressure on asset values, and slower-growth markets are particularly susceptible to erosion of asset values. This is primarily a result of NOI growth being insufficient to offset rising interest rates, whereas gateway markets tend to experience stronger NOI growth and are better equipped to absorb capitalization rate increases. Rising capitalization rates with limited NOI growth could cause residual values to decline and, consequently, total returns to decline as well.
Many risk concerns relate to secondary markets’ smaller size and structure, which can limit economic growth, depth of investor interest, and overall liquidity across the economic cycle. Unlike gateway markets such as San Francisco and New York City that tend to have very high barriers to entry, midwestern and southern markets such as Cincinnati; Raleigh, North Carolina; and Atlanta have greater land availability, causing supply concerns since the potential for competing development may be higher.
Diversify Your Portfolio
Despite material risks, the potential benefits of investing in secondary markets as a component of a larger real estate portfolio strategy are appropriate for today’s investors. Since developing a balanced and diversified real estate portfolio requires components of income and growth, it is prudent to allocate a percentage of a portfolio to income-oriented investments in select secondary markets with strong economies and underlying supply/demand fundamentals.
The first step in a secondary-market investment strategy is to develop a portfolio overweight to property types that are known for historically strong and durable income and cash-flow returns (such as multifamily and retail properties). Although industrial investments can produce strong income yields, NOI growth can be difficult to attain on a consistent basis, whereas office space is generally the least favorable property type for income-oriented buyers because of the high cash-flow volatility. During the asset selection process, investors should target institutional-quality investments that ensure the highest degree of income and cash yields through outsized tenant interest and lowest levels of capital investment. Selection of best-in-class assets and locations within these markets should lead the market in NOI growth and provide some degree of insulation from future supply risk.
Market selection is critical, and not all secondary markets are created alike. Investors should prefer markets that demonstrate a strong economic composition that will ensure that NOI growth potential is maximized and sustainable. Markets such as Nashville, Pittsburgh, and Austin, Texas, represent some of the most appealing secondary markets since their knowledge-based economies are built on growth-oriented industries such as technology, health care, and education. These fields attract an educated workforce, ensuring that meaningful investor interest in the market is consistent throughout the economic cycle. Houston is perhaps the best example of a secondary market with a strong underlying energy-based economy that is quickly garnering gateway-market status through significant investor interest.
Historically low (though rising) interest rates, coupled with elevated cash-flow yields, allow for more substantive leverage levels than typical core investments do. However, investors should exercise prudence, given that refinancing may grow more difficult due to rising interest rates, potentially declining asset values, and concerns about overall NOI growth.
The fierce competition for real estate investments in gateway markets, due in large part to the significant amount of capital available in the financial system, has caused primary markets to become incredibly expensive. Excess capital has been flowing into secondary markets, which presents both opportunities and risks. Through a thoughtful investment strategy that focuses on the highest-quality markets, locations, and assets, investors can navigate the drawbacks of secondary markets and provide a substantive income component to their overall real estate portfolio.
Matthew Cypher, director of the Real Estate Finance Initiative at Georgetown University’s McDonough School of Business, is a professor of the practice in real estate finance.
