What is the most desirable city to live in? For many people – particularly after almost three years of the pandemic – preferences are changing. Fast-growing cities outside of gateway markets that offer lower living costs are a magnet for people seeking a higher quality of life. And where people go, real estate investors will follow.

AFIRE’s 2022 International Investor Survey found that 71 percent of investors in the US are planning to increase their level of investment in secondary cities over the next five years. Atlanta, Dallas and Seattle, which the survey classifies as secondary cities, all feature in the top five US cities for planned investment. Austin, billed as a tertiary city, even ranked in second place.

“These are markets that we are very bullish on and continue to invest in,” says Jordan Kabbani, who leads the US research department at real estate firm Greystar. “I would, however, consider Seattle more of a gateway market and Austin wouldn’t be tertiary. Austin, Atlanta, Dallas, Raleigh, Durham – you could call them secondary cities, but we call them ‘growth markets’ generally.”

Indeed, how cities are categorized is highly subjective, market participants canvased by PERE note. But regardless of which cities are ascribed to different tiers, all of them agree these secondary – or growth – markets are on institutional investors’ radar due to a convergence of talent, quality of life and real estate performance.

In the US, the rise of secondary cities – most of which are located in the Sun Belt, including the Mountain West – is linked to “tremendous growth fundamentals” seen before the pandemic, Kabbani explains. These cities have been attracting capital as they experienced stronger net migration, household formation and corporate relocations.

“Coming out of the pandemic, we saw a lot of movement to those cities that really accelerated that household formation. So, when we look at demand for housing in general, but also rental housing specifically, those markets screen very well,” Kabbani says.

For David Steinbach, global chief investment officer at Hines, the secondary locations highlighted in AFIRE’s survey are cities that have been offering good opportunities for a long period of time, and where the Houston-based real estate investment firm continues to see growth. Other locations, such as Nashville or Salt Lake City, for instance, are also attractive as they provide a yield premium when compared with cities that price more keenly, like Austin or Denver, Steinbach notes.

“Coming out of the pandemic, we saw a lot of movement to those cities that really accelerated that household formation”

Jordan Kabbani

Investing in secondary cities is about following demographics, Steinbach explains. The millennials who moved to gateway cities during their university and early employment years, for instance, are now middle aged, and many of them have families. That translates into different living requirements, such as a need for more space, while still wanting to be in an urban environment.

Following the people

Millennials, Steinbach notes, are often also moving back to where they came from. “It’s interesting to think about what they’re going to want when they go to Salt Lake, Austin or Seattle,” he says. “I think they’re going to bring a lot of the urban sensibilities that they acquired when they moved to the gateway cities. And so, the play isn’t to build a 1950s suburbia. They want something that feels more like what they love – these mixed-used, more complicated schemes [but now] in secondary cities.”

Brian Klinksiek, head of European research and global portfolio strategies at LaSalle, notes the primary reasons secondary cities become investment targets are fundamental growth in attracting residents, businesses and cultural capital, or soft power – the brand of the city and whether it seems like an interesting place to go to.

“Covid has been an accelerator of that in parts of the world where there’s more working from home,” Klinksiek argues. “People who have cost of living constraints in major cities – and are not expected to be in the office as frequently or at all – can have the flexibility to move to some smaller places that have a high quality of life, good housing, and all for a good price.”

“These cities are often places that people want to visit, tourism economies, so hotels can attract investment as well”

Paul Tostevin

In the UK, the city of Bristol illustrates this trend. “It is an interesting UK secondary city and benefited from being an alternative to London for its quality of life and cost of living,” Klinksiek says.

Bristol – and other UK secondary cities like Sheffield or Leeds – are currently attracting capital from large private real estate firms that are “taking a long-term view” on single-family rental schemes, says David Jerrard, chief credit officer at alternative lender Précis Capital Partners. These firms are investing not through one-off deals, but by building portfolios, as people seek housing affordability in new locations, he notes.

The need for residential schemes to house these growing populations is indeed the major draw for investors coming to these markets. “Investment into secondary cities is about beds in general. And then typically student housing if it’s a university play, or care homes if it’s a demographic play,” says Paul Tostevin, Savills’ head of world research.

However, there are also other property sectors in these markets that are attracting investment. “These cities are often places that people want to visit, tourism economies, so hotels can attract investment as well,” notes Tostevin.

Office is another draw, particularly in those markets underpinned by knowledge industries. In this sense, Eindhoven in the Netherlands – a big hub for tech companies and home to over 12,000 researchers – is an interesting standout, Tostevin says. “It offers that cost-of-living angle – it’s cheaper to live there than in Amsterdam – and has a strong pipeline of office development, so there are certainly good opportunities there going forward,” he adds.

In Asia-Pacific, Yokohama has re-emerged as a research and high-tech industrial hub. It is also a residential play, because of its strong affordability, Tostevin says. “It’s commutable into Tokyo itself. So that’s an interesting market to watch.”

LaSalle’s Klinksiek notes that those sectors that “really thrived” during covid – not only residential but also logistics and niches like self-storage – have seen the most investment in these secondary cities. “In China, one of our investment focuses in secondary locations is the logistics sector.” LaSalle has done recent logistics acquisitions in cities like Nanjing, Tianjin and Jinhua.

Chasing yields

Investors willing to go beyond gateway cities in search of cheaper land or assets are likely to also be searching for higher yields.

In the US, for instance, costs of both for-sale and rental housing are rising much faster in secondary and tertiary markets as people fleeing pricey gateway markets bid up residential prices in the smaller destination markets, according to the Urban Land Institute’s Emerging Trends in Real Estate United States and Canada 2022 report.

“Returns have come in as people have become more interested [in secondary cities]. But chasing yield, for us, isn’t a reason to go there; it’s about how we can create value to what’s happening there and do it in a way that we get upside returns,” argues Hines’ Steinbach.

Justin Meissel, chief investment officer at Henley Investment Management, a London-based private equity real estate company that has property assets in secondary locations across Europe – including Poznan in Poland, and Salford in the UK – says the key to achieving higher yields is to find assets in “strong” micro locations that need “a bit of work or a bit of love” to improve them. “That could be by place-making or by capex that we do when we look to make an impact locally.”

Meissel notes that nine months ago, before interest rate increases and cap rates started to move, investors could typically get anywhere from 50-150 basis points of yield if they moved into secondary cities. The “dramatic” movement in interest rates, however, will likely impact valuations and the pricing that real estate trades at, he says.

“In a primary market where yields are tighter, the percentage impact is much greater, because the yield is smaller. A 50 to 100 basis point movement in a cap rate [of an asset in a primary market] is going to have a bigger impact than when cap rates are 5 or 6 percent. But obviously liquidity will impact secondary markets much more dramatically than in primary markets,” Meissel argues.

While gateway cities are more liquid markets with a much deeper pool of investors, the trend of diversifying into secondary cities is here to stay, industry sources agree. As investment volumes have returned to pre-pandemic levels, yield compression and increased costs have pushed more investors to look beyond primary markets – something that is likely to continue.

For Hines’ Steinbach, the explanation is simple: as real estate becomes more of an established asset class for investors, all the investable capital cannot flow only to gateway markets. “It just doesn’t make sense. It’s going to follow people. So, I think [investors] will end up continuing to push out to other markets.”

The lure of affordability

Can secondary markets help counter spiralling costs?

Driven by energy price increases, construction costs rose 11.5 percent last year, significantly above the 2.4 percent historical trend, according to CBRE’s 2022 US Construction Costs report. That surge is on track to continue this year, with costs projected to rise 14.1 percent by the end of 2022, according to the report.

Investors canvassed by PERE note the impact of rising energy prices on construction is a universal challenge, and certainly not a gateway market risk in particular. But some of the advantages secondary markets offer – including cheaper land and lower labor wages – could help attract investors in this period of cost volatility.

Précis Capital Partners’ David Jerrard says that after strong investment over the last few years in London and other major UK cities like Birmingham or Manchester – and as operating margins have been squeezed due to cost inflation – private equity real estate groups are looking for more affordable development sites, which are usually found in smaller cities.

“Land price is one of the largest factors as to how profitable a scheme is. So, we see interest in some of these other regional cities, where cheaper land prices assist site viability,” Jerrard says.