Beyond the Big Cities: Strategic Investing in Secondary and Tertiary Real Estate Markets

Real estate investing often makes headlines (good or bad) based on the performance of a handful of major metropolitan markets. “Gateway cities” like New York, Los Angeles and Chicago have long been a focal point for institutional capital and high-net-worth investors; and for good reason – these markets have global appeal for both potential tenants and buyers alike and, as a result, are often considered more liquid than real estate in other markets. However, demographic trends over the last decade have caused secondary and tertiary markets to gain attention of some savvy investors, who have found compelling investment opportunities.

Understanding Market Tiers – While the “primary markets” are relatively easy to identify given their global recognition, the definitions of secondary or tertiary markets are more ambiguous. A “secondary market” is generally a metropolitan area with a population over 1 million residents (Think: Denver, CO, Charlotte, NC, Austin, TX), which exhibits growing economic and demographic fundamentals. These markets have increasing investor interest and are experiencing increased development. A “tertiary market” in comparison, is often defined by a smaller population (generally less than 250,000 residents) and limited institutional investment but may show signs of growing demographic trends and economic growth as these communities seek to attract new businesses (Think: Des Moines, IA, Fort Wayne, IN, Huntsville, AL). While primary markets offer prestige and liquidity, the growing attraction to commercial real estate in secondary and tertiary markets stems from identifying value and potentially stronger cash flow, for those willing to take a more hands-on approach.

The Case for Investing in Smaller Markets – A primary consideration in commercial real estate investing is identifying value. Those investors who can identify potential value and execute a strategy to realize consistent cash flow will often win the day. Gateway cities tend to be more efficient markets, given the amount of data readily available, making it difficult to identify unrealized value. Many of the commercial real estate programs tracking market data will not follow markets smaller than a certain size, and those that do often have a difficult time obtaining accurate sales and leasing information. The lack of information and uncertainty about an exit strategy will cause institutional investors to look elsewhere; creating opportunities for investors who understand the dynamics of smaller markets to acquire assets at favorable terms and create value through renovations, improved management or repositioning of an asset.

Institutional investors will also tend to overlook smaller markets simply due to their scale – given the amount of capital needed to be deployed, it is inefficient to pursue what are relatively smaller investments. As a result, there is less competition in smaller markets, and those who understand the market trends, can often negotiate better pricing and often avoiding bidding wars.

Assets in smaller markets also tend to have lower operating expenses. These reduced costs are due in part to: (1) the lower overall cost of living (maintenance and management); (2) generally lower assessed property values and less demand for community resources than larger markets (taxes); and (3) lower crime rates and a reduced risk of catastrophic events (insurance) as secondary and tertiary markets are less likely to be in high-risk zones. When executed well, a lower acquisition cost, coupled with lower expenses can lead to higher cash-on-cash returns to investors.

Risks to Consider in Smaller Markets – While the upside can be compelling, investing in secondary and tertiary markets is not without challenges. One of the primary risks is liquidity. There are fewer buyers and lenders operating in smaller markets and finding a buyer or refinancing can take longer. Those who invest in smaller markets need to account for longer hold periods and ensure they have adequate reserves and financing flexibility. Similarly, the pool of potential tenants may be smaller, meaning that re-tenanting may take more time or require concessions. As a result, additional reserves may be warranted until a new tenant is found.

An investor will need to be diligent when entering a new secondary or tertiary market. Not all smaller markets are thriving, and investors will need to understand the communities’ reason to flourish. Communities reliant on a single industry will be more vulnerable to economic shifts. Those markets that have seen the most growth and investment in recent years have one or more of the following institutions: a research university, major hospital system, government employment sectors or logistical hubs. These institutions provide a significant number of jobs and attract talent, which in turn fuels economic growth. In addition, markets with these industries tend to be more resilient during economic downturns.

A Strategic Play for the Patient Investor – Secondary and tertiary markets offer a compelling blend of value, cash flow and diversification for real estate investors willing to do their due diligence. While they may lack the glitz of primary markets, smaller markets often provide more predictable income and less competition. The key for investors is to identify markets with strong demographic fundamentals and a diverse set of economic drivers. For those who are looking to build a resilient real estate portfolio, secondary and tertiary markets may just be the hidden gems that deliver outsized returns over time.