Forget the Sexy Six: Why These Investors Love Secondary and Tertiary Markets
July 28, 2015
Secondary and tertiary markets are getting their day in the sun as employment grows and the economy improves across the U.S. Commercial real estate has picked up as a result, with transaction volumes and leasing activity booming in cities where technology is king.
To find out where the next hot markets are, EisnerAmper tax partner Lisa Knee gathered Clarion Partners director and head of investment research Tim Wang, Treesdale Real Estate Partners managing partner Oliver Swan, True North Management Group CFO Desmond McGowan, EVOLVE President Chris Fraley, and Yardi Systems VP of Matrix Products Jeffrey Adler to discuss their secondary and tertiary market insights at IMN’s 16th annual U.S. Real Estate Opportunity & Private Fund Investing Forum, held at New York City’s Grand Hyatt on June 15.
Knee launched the discussion by asking panelists what asset classes they're targeting and what competition they're experiencing.
Wang said that Clarion is targeting all property types, and finding this cycle more competitive than the last, particularly from foreign capital and family offices. A few weeks ago, it bid on the Mercedes-Benz dealership at 770 Eleventh Ave. and was beaten by a hedge fund.
True North is agnostic about property types and markets, McGowan replied; instead, it tends to look for the intrinsic opportunity and winds up with portfolios that are typically 50% to 55% office buildings. The only property type it’s avoided is retail, he said, because the opportunity there has been less compelling than office buildings. It’s all about finding buildings with good bones and staying away from the markets where cranes are going up.
Swan noted that Treesdale focuses primarily on opportunistic situations, so it’s always looked in secondary and tertiary markets. However, he’s found that transactions take longer to close and it takes more time to build relationships in those markets. “We’re now bearing the fruit of work we started five years ago.” But building those relationships means that Treesdale is able to go in and out of markets as opportunity dictates.
EVOLVE focuses on assets it can revamp into highest and best use, so Fraley reported that there isn’t much competition in his space. His deals also tend to be a bit smaller.
Knee then asked the panelists if they were running into more real estate funds in the secondary and tertiary markets.
There’s greater activity, McGowan replied, but the point he makes to his investors is that there is an awful lot of room in the sandbox. (His favorite definition of secondary and tertiary markets is how many connecting flights you have to take to get to them.) There’s a migration into the urban core, and it’s not just happening in coastal cities, but within every state, he contends. “There is a surprising amount of depth in these markets and cities you may not even think of.” As far as competition, True North tries to stay above the family office by doing deals they can’t easily line up on their own, yet staying under the radar scope of the big funds. “We’re not going to do a $50 million deal, at least not in the near future.”
One reason you don’t have many large funds in these markets is simply because they don’t get involved in transactions that require less than a $10 million to $15 million equity check, Swan pointed out. “In a lot of these markets, you don’t have these kind of deals,” he said. “And even if you have one or two, the risk profile is off the chart. That’s always the biggest detriment for large funds.”
Another reason, both Wang and Swan noted, is that these markets have barriers to entry—ones different than you’d find in New York. “The markets have plenty of land and plenty of local real estate owners and developers,” Swan said. “The biggest barrier is complexity. A lot of developers and owners in these markets don’t have the expertise to build 12, 13, 14 stories, even in steel—they use wood-frame construction.” Given their size, there are both physical and financing structures they don’t have access to.
What type of capital is available in these markets, Knee asked, and what are the spreads like?
Swan said that from a debt perspective, there’s not a tremendous difference—there’s only a slight spread in pricing between construction loans in primary and secondary/tertiary markets. There’s also a slight different in leverage, but a strong local developer can compensate for any spread in pricing. Equity is a different story—as there are fewer players in the market, you have pricing that is both much wider and all over the map, he explained. “It’s a Catch 22,” he said. “If you have a medium-sized deal, no large fund or equity partner is going to want to go into a market like Kansas. Unless you have a high net worth or syndicated platform, it’s very difficult to raise institutional equity.”
Equity partners are aware of this and have to price for transactional risk, he continued. “It’s also a double-edged sword—it comes back to haunt you when you’re looking to sell, because your buyer has the same exact problem… and it’s 10 times more difficult for the next buyer.”
Knee then wanted to know why certain regions attract investor interest and others don’t in the secondary and tertiary markets.
Adler said that it comes down to analytics. We know about the “Sexy Six,” which have large, diversified nodes of intellectual capital and are broadly diversified with world-class knowledge—for instance, Los Angeles for entertainment, San Francisco for tech, and New York for finance. He said he’s looking for the conditions under which the next tier of cities begin to make it; diversification then changes the liquidity premium.
Questions to ask, he continued: What’s the intellectual capital node? What’s the business climate? What supports the creation and retention of intellectual capital? Are public-private partnerships available? What’s happening in terms of amenities? The potential black swan is access to quality education for the poor—if they don’t have access within a given city, you’re creating the seeds of self-destruction, he contends.
“Anyone who grew up in New York in the ‘70s remembers what it was like,” he recalled. “Millennials have no idea what an unsafe urban environment is about. The reduction of crime in the past 20 to 25 years has been unbelievably positive, and has created more zones in secondary areas of primary markets and cores of secondary cities.” Only then do you see the outcomes real estate folks look for: job, wage, and population growth.
The identification of core is constantly changing, Fraley pointed out. For instance, the DC metro was about the Rosslyn-Ballston and I-270 corridors in 2000; investors were nervous about going to the Dulles Toll Road. By 2004, they had gotten more comfortable, and by 2006, as long as the broker could say “DC metro” in an email blast, it was considered core. But in 2008, everything shrunk back to Downtown DC, Bethesda, and the R-B Corridor. “We’re not at 2006 levels yet, but we’re not too far away,” he said of the region.
While DC has recovered faster than other markets, oversupply in Northern Virginia, coupled with defense pullback, has changed Reston from primary to secondary and now back to primary. “You can’t price it that quickly,” Swan added.
Adler noted that there is a supply-demand balance in the North Carolina Triangle area, Austin, and Nashville. Some places don’t have sustainable intellectual capital nodes, like Jacksonville, Phoenix, Orlando, and Las Vegas. (“You can make money there if you time it just right and you’re in and you’re out,” he said.) And then there are cities where infrastructure isn’t filled in; expect to be there at least 10 years of participation in building that civic infrastructure.
You really have to know what’s driving the market when you look at a building, McGowan said. “You have to ask yourself if intellects want to work in the building.”
Take Orlando, which Swan called “complicated.” You have huge school enrollment at the University of Central Florida (UCF); theme parks; a huge working middle class that predominantly lives in garden-style multifamily; casinos and hotels; and a racial divide. “Whether you're looking to own student housing or retail or office, you really have to understand every one of those submarkets within that market, their interaction, and how they change over time.” The area around UCF has changed dramatically over the last five years, he noted; so if you're only flying in once a year as an investor, there’s a good chance you’ll get burned. So many investors and developers are local, and they're going to catch opportunity a lot faster than you are as an institutional person from NY or Boston.
Wang said he noticed that the millennial intellectual capital is also about price, and they’re moving to places like Denver, Austin, Salt Lake City, and Raleigh. Observing that jobs follow this talent gives you a competitive advantage, he said.
Foreign capital has always been attracted to gateway markets, especially the “Sexy Six,” Knee noted. She asked the panelists that if prices continue to rise, will foreign capital be more prevalent in secondary and tertiary markets? Wang thinks the majority will stay in primary markets, while Fraley noted that many Asian investors are particularly going into Downtown Los Angeles.
Cities that excite the panelists: Atlanta, Kansas City, Denver, outer boroughs of DC, Raleigh, Richmond, San Jose, Miami, and Downtown LA. (No one said Detroit, much to Michigan-native Knee’s disappointment—but there’s always next year.)