By Trevor Hanson.
Over the past decade, an increasing number of private and institutional real estate investors have branched out into smaller markets in order to meet investment metrics and achieve higher returns. For example, more than 55% of multifamily properties bought and sold for over $1 million in 2017 were located in secondary and tertiary markets—up from just 42% in 2010. The question investors often ask is, “What drives the growth in these markets and how can they be identified?” Research shows that there are several benefits of investing in seemingly unsuspected areas, despite the focus of industry headlines on primary and gateway real estate markets. Before delving into the where’s and why’s however, it is important to understand how these markets are defined in the first place.
Defining Non-Primary Markets
Real estate investors, lenders and experts alike can define markets in a myriad of ways—increasing potential for confusion when facing a non-primary market transaction. Market classification varies depending on who is asking, for what purpose, and by what criteria that an opinion is formed. Due to these variations from institution to institution, it is quite clear that there is no concise definition or “fine line” as to what differentiates these smaller real estate markets from their neighboring primary ones.
Instead of narrowing down to a single indicator, such as population numbers, a more holistic approach is to create a matrix of information—including both traditional and non-traditional economic drivers. For one, finding exactly where a market fits within our nation’s appreciation-depreciation continuum is a difficult aspect of making such investments in non-primary markets. There exists a plethora of key indicators and metrics that inside experts religiously analyze before taking action. Some of these indicators fall into the so-called traditional real estate valuation metrics category—cap rate analysis, rental/cash flow yields, availability of debt, and sales/investment volume—while others fall in line with more demographic or traditional qualitative measures—population growth, housing supply, affordability/relative average homes prices, local economy growth/labor market growth, home appreciation rates, and occupancy levels. It is of paramount importance to understand all the moving parts of a market before making an investment.
Advantages of Smaller Markets
What makes investing in secondary and tertiary markets so appealing in this day and age? First, such markets are much less volatile in downturns, making investments uniquely more attractive late in the investment cycle. Second, deals and properties in these markets tend to not be overvalued and often, produce higher returns as well. Lastly, these markets tend to have lower cost of living and less housing supply, ultimately reinforcing the notion that a market exists to fulfill such an investment and inhabit such an investment property.
The overarching issue to the aforementioned differentiators is that they are volatile over time, making the timing of the market an extremely difficult endeavor. In other words, hot cities to invest in rental properties typically change over time. A once-affordable city may now be overvalued and inflated—think Denver and Seattle. Conversely, a once booming economic center may now be depressed and depreciating—such as Oakland or Detroit. In order to identify a market with high potential, it is important to take all of the aforementioned factors into account.
Summary and Next Steps
As market fundamentals evolve alongside investment strategies and sophistications, it will become increasingly difficult to label specific markets. Some key takeaways would be to (1) analyze hard data in smaller markets and compare it to said economic drivers at a national level; (2) consider outside factors in addition to traditional economic drivers—this helps to avoid a narrow or inaccurate view of a local economy; (3) compressing cap rates historically indicate a competitive investment environment—look at 10 year spreads for higher yielding assets; and (4) invest in markets that you KNOW—cities or neighborhoods that you or your investment partners are personally familiar with and have seen change or progression in.
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CoreVest provides attractive long-term debt products for stabilized rental portfolios as well as credit lines for new acquisitions. For more information about how CoreVest can help you grow your rehab or rental business, please call Trevor Hanson at 347.894.2552 or email firstname.lastname@example.org.