Beyond the gateway: Investment considerations for secondary cities

In recent years, direct investment in commercial real estate has been heavily concentrated in a few cities such as New York, Washington and Los Angeles, which are considered safe havens during times of market uncertainty. 2013 saw a big jump in U.S. property investment, with much of the new money coming from foreign sources most comfortable with these “gateway” cities. As cap rates in those cities fell, many investors looked to secondary cities, as well as some smaller markets with good growth prospects.

While it's true that up-and-coming cities can offer higher going-in yields than investors can expect to get in Manhattan, a broader geographic strategy can also hold additional risks. The key to investment success is maintaining a disciplined approach in markets that demonstrate strength.

Commercial property markets were hit harder by the recession in some cities than others, and some cities have recovered more quickly. In fact, our analysis shows the cities with the lowest rate of job loss during the recession have also outpaced most other cities in terms of job gains in the recovery. In other words, some cities are expanding again while others are still well below the previous peak, in terms of rent and occupancy.

So a secondary-market strategy has a potential reward in the form of higher going-in cap rates, but there is also greater downside risk. By understanding the factors that can affect financial performance, investors can make decisions that best meet their risk and yield tolerance.

The success of real estate investment is based on the future demand for space, so everything revolves around tenant growth patterns. One challenge — and opportunity — is that demand in the future might not resemble the past. There is risk in the assumption that companies, retailers and apartment dwellers will want the type and location of space in the future that they have wanted in the past.

In the past several years, three-quarters of all jobs created have been concentrated in a handful of industries: education, health care, energy and technology. Of the four, only the tech field has resulted in a lot of office jobs, and those jobs have gravitated to what we call “innovation markets.” In general, innovation markets are cities with a high percentage of college-educated residents, and where the business community generates a lot of patents.

Tech companies frequently locate in work-live-play neighborhoods with office space that's affordable to startups, and apartments and retail choices that appeal to Millennials. These high-tech magnet areas might be secondary or tertiary cities like Seattle and Austin, Texas, or they might be neighborhoods outside of the core business districts in large cities, such as Chicago's River North, with a mix of office, apartment and retail, often created from converted industrial sites.

Tenant demand can also be targeted to certain product types. For example, medical office buildings on or near hospital campuses are increasingly desirable regardless of the state of surrounding core property markets. And in the industrial sector, demand is high for new “big box” distribution centers equipped for both online sales and traditional store shipping.

Investor demand is also a factor. Too much competition drives up prices, and the smaller the market, the more easily it can become overcrowded. Typically, investments in smaller cities have higher going-in yields than in large cities because more investors are comfortable competing in New York and Washington. But smaller growth cities that everyone knows about, such as Austin and Raleigh-Durham, N.C., might attract more competition than their size can support, resulting in a narrow spread in yields compared to gateway cities.

Smaller markets don't work for all investors. Investors that focus on a few markets might not be confident they can find enough good deals in a secondary city to make it worth their time to follow the market. And if a city doesn't have a large enough stock of big-ticket buildings, large institutional players might take a pass — when you've got $1 billion or more to invest annually, you can't reach the goal in $10 million increments.

Another risk of secondary cities is that they might be overly dependent on a few companies or a single industry segment that could turn down. Smaller markets often lack resiliency; the loss of one large tenant, or a new megadevelopment coming online, puts much greater pressure on a small city than a large one.

Balancing the added risks, secondary cities offer higher average cap rates and strong upside potential to investors willing to venture beyond gateway markets. Here are some strategies to mitigate the risks and position for maximum gain:

• Don't spread yourself too thin. Select a handful of secondary and tertiary markets to monitor closely, rather than chase high-yield deals all over. Without a thorough understanding of the underlying market conditions affecting an investment, risk-adjusted yields can't be accurately assessed. By choosing markets wisely and tracking their progress, you might have a competitive edge of superior knowledge when the right opportunity comes along.


• Focus on the best property types. It's often good to select one or two property types to pursue in each market, in order to maintain an in-depth, focused approach while diversifying by geography and asset type. For example, you might pursue residential and retail properties in Austin and distribution in Las Vegas.


• Go where the Millennials are. The generation that today is 18 to 35 years old will become the largest cohort in the working world in just a few years, and as the most tech-savvy generation, they will be in demand. Millennials are renting longer and living in cities longer than previous generations, and they favor live-play-work neighborhoods in innovation markets anchored by job drivers, and often near universities. These areas are likely to continue on a steady growth pace and will outperform most other markets over the next several years.

An investment strategy that combines gateway and secondary markets can produce strong yields, but it's important not to lose focus. Direct investment in commercial real estate is the polar opposite of a commodity — success requires in-depth market knowledge and continuous vigilance during the investment period. That might limit the number of smaller markets in which an investor can prudently invest. But done right, the incremental yields from these off-the-beaten-path investments are worth the extra attention.

Chuck Burd, CIO of Bentall Kennedy, has responsibility for creating investment strategy and policy, and overseeing the firm's separate account business in the U.S. In addition, he serves on Bentall Kennedy's U.S. Executive and Investment committees.