HOT MARKETS: Beyond the gateways

Competition for institutional-grade commercial real estate in the US is intensifying as capital sources around the world seek relatively safe long-term investment opportunities. For some foreign investors, current yield is less important than preservation of capital and the promise of higher values in the future, even if that future is decades away. This flood of capital willing to accept low cap rates is effectively pushing yield-oriented investors out of the gateway cities familiar to foreign investors and into secondary markets, where competition is not as intense. The question is: which of the country’s top 100 metropolitan areas will produce standout results for investors over the next five to 10 years?

New York, San Francisco, Washington DC and a few other coastal cities are ‘gateway’ markets for several reasons: they’re familiar to global investors, they’re resilient in the face of economic downturn and they have enough large properties to maintain a steady flow of institutional investment opportunities. When a capital source decides to look beyond these six or eight markets for acquisition or development opportunities, there are dozens of potential metropolitan areas from which to choose. Most investors should not chase deals in every city, even if the numbers are good.  Real estate equity is the furthest thing from a commodity investment, and a property that produces great cash flow today could be a terrible long-term investment for reasons that investors would know only if they follow that market closely.

There are two general components to determining which cities make the best targets for office, retail and apartment investment. First and foremost is the strength of market growth fundamentals. If a market shows potential for growth, investors also should consider the depth of opportunity, based on factors such as market size, economic diversity and the level of competition. Investors should have confidence in both components before committing their focus, and that of their investment managers, to a secondary market.

Predicting market strength 

As investment funds are obliged to tell prospective participants, past performance is not a guarantee of future success. This is definitely the case with real estate markets, which are subject to up and down cycles based on a range of factors. Therefore, looking at job growth, occupancy rates and asking rents in past years is not a great way to predict a market’s performance in the future. Those factors are important, of course, but they are only part of the equation.

Markets for office, apartment, retail and mixed-use properties, which represent the vast majority of urban acquisition and development opportunities, rely heavily on their ability to attract professional and knowledge workers. In the past, these workers gravitated to cities where there were jobs. However, as companies increasingly pursue a smaller pool of top talent, the dynamic has shifted. Companies are moving or expanding their presence to areas where young, college-educated people want to live. This is especially the case for technology companies, which have been responsible for the lion’s share of new, high-paying urban jobs over the past several years.

In the past several years, approximately three-quarters of all new jobs created have been in four industries: education, healthcare, energy and technology. Of the four, only the tech field drives a lot of office jobs, and most of those jobs have been concentrated in ‘innovation markets’.

Austin and Raleigh are two of the fastest growing cities, as companies in the tech sector have relocated or expanded into those markets to attract talent. So, what factors have helped those and other high-growth cities attract knowledge workers? A strong correlation can be found between growth cities and certain predictive criteria:

Education levels – The percentage of an area’s residents who have advanced degrees is a strong indicator of that market’s near-term growth. Areas with top-ranked universities for computer science and research, such as Austin and Raleigh, get an extra boost if students like the area and decide to stay after graduation.

Patent activity – Cities that generate a lot of patents tend to see strong job growth follow. Universities also can drive patent activity, especially if they have partnerships with private-sector businesses to engage in advanced research. Civic and government leaders foster innovation with incentives and infrastructure to encourage neighborhood rejuvenation and business start-ups. San Francisco and Silicon Valley still lead the country in generating patent activity, but hot markets such as Austin, Raleigh and Seattle all outperform other secondary cities for patent activity, even when other education-based criteria are considered.

Entertainment and social amenities – Millennials, the generation most sought after by companies, tend to choose work-live-play neighborhoods with good mass transit accessibility. As a group, Millennials value possessions less and experiences more than previous generations, so a youth vibe fueled by a thriving music or art scene can help a city attract residents, who in turn attract jobs.

Resiliency – Our analysis shows that cities that experienced low net job loss during the recession generally have gained the most net absorption in the post-recessionary period. This is the reverse of past recessionary cycles, when cities that reached the highest vacancy rates were often among the first to start recovering, due in part to the decline in effective rents. This time around, Austin, Houston, Dallas and Denver – the cities least affected by the downturn – have continued to see strong demand during the recovery, while other cities that were hit harder have yet to fully bounce back.

In examining cities for strong job growth prospects, it’s also useful to look for a balance of product types. Office, retail and multifamily residential growth and development complement each other. If a market appears to have more loft office space than affordable apartments to house workers or if there aren’t enough coffee shops and retail services to support a growing population, that could represent an imbalance that limits growth—or it could mean a great development opportunity is there for the taking.

Naturally, some property types are subject to a different mix of demand criteria. Industrial growth depends on distribution trends and a market’s suitability for e-commerce product, while the value of a medical office building depends heavily on its proximity to a hospital. Suburban markets shouldn’t be dismissed as potential opportunities for good investment. However, for office or apartment investors looking for the best possible markets for investment, urban innovation markets provide the best market opportunities for solid growth.

Sizing up the opportunity 

Investors that pursue a secondary market strategy typically are seeking higher going-in cap rates than they can get in gateway cities, but this higher reward comes with greater downside risk. It’s important to examine not only the space demand factors that drive growth, but also the capital supply factors that affect competition.

The presence of too many bidders for a particular property tends to drive up the acquisition price. Gateway cities usually are large enough so that there are always properties to bid on, even though there may be many bidders as well. Smaller markets can become overcrowded with investors more easily, especially when their success is widely known. Indeed, some investors are concerned that Austin and Raleigh already are seeing too much competition for a relatively small number of acquisition opportunities, effectively narrowing the spread in yields compared to gateway cities.

In addition, some secondary markets may be too small for institutional investors regardless of the level of competition. Investors that focus on a few markets closely enough to make smart decisions want their investment in time and effort to pay off with multiple acquisitions or developments in those markets. If there are not enough large properties in a market changing hands regularly, it may not be worth the bandwidth to follow the market.

Yet another risk to investing in a secondary city is the potential for an unexpected economic shock. Some smaller cities are heavily dependent on one or two companies or a cyclical industry that could turn down. The loss of a large space user or the delivery of a major new development can threaten the health of real estate markets in some secondary cities—a problem that gateway cities rarely face.

What if a market has a good growth story but not enough inventory to meet the potential demand? That’s where development comes in. In this recovery cycle, development came first to the urban apartment and e-commerce distribution sectors, the former concentrated in established work-live-play markets and the latter concentrated outside but near urban centers to accommodate the same-day delivery trend in online sales.

Secondary cities with good growth prospects are seeing more new development opportunities, generally funded by capital sources with local market experience. A new entrant into a market may not want to undertake development deals right away, but it’s still important to be aware of these deals as they can affect competition for tenants and investment yields.

An investment strategy that targets secondary markets can produce strong yields, but it requires in-depth market experience and disciplined due diligence and underwriting. For most investors, the best program is one that focuses on a select group of secondary markets that offer strong growth potential and sufficient deal flow in line with the investor’s strategy. Like any good real estate investment, secondary markets require time and patience as well as business savvy, but the rewards can make it more than worthwhile.