Tertiary Markets Discussion

Secondary and tertiary markets have increasingly become a focus for real estate investors of all types as the numbers on deals, especially in primary markets, stray further and further from making sense. Going further out on the risk spectrum by investing in smaller markets is called “reaching for yield”. But is this just a late-cycle trend or a viable long-term investment strategy? And are yields higher in tertiary markets because they truly are higher risk or is it because those markets are overlooked and their risk exaggerated? I believe this is very market dependent and playing in the tertiary market space allows for manager alpha through superior deal selection. 

Given our strategy of short to mid-term investments and focusing on increasing cash flows and value irrespective of market growth, almost any stable market becomes a viable place to invest. This means we don’t necessarily need to be in the hottest growth market or in a strong macro-market to achieve compelling returns. Additionally, the “hottest growth markets” usually are no secret and attract disproportionate competition, effectively reducing the growth opportunity from being a bonus to a necessity in order to meet projected returns due to elevated pricing. Values always factor in consensus growth assumptions and therefore the benefits of market rent growth are embedded in the price. For example, fabulous mid to long-term returns have and can be achieved in places like California and New York but the underwriting of those projects must assume very high rent growth. At this point in the cycle, making such assumptions can feel intimidating, given the high level of sustained rent growth already experienced over the past five years or more. Instead, it may be easier to buy into acquisition theses in tertiary markets as the assumptions are based on low rent growth, stable asset performance, and modest cap rate expansion. 

Richard Barkham, global chief economist with CBRE recently said, “Time to revise our notions of what is secondary and what is tertiary. Lots of tech demand in smaller markets that I don’t think is going away. Invest in high-amenity locations wherever they are. Consumers are confident, and the service sector is doing well. Interest rates [being lowered] should strengthen these trends and boost office and retail sectors.” (NREI Online). 

Furthermore, tertiary market investments usually achieve more of their returns from cash flows rather than appreciation, which is a more dependable formula than the other way around. It is very difficult for deals to pencil these days and operating assumptions can only be so aggressive. The only thing left to do is to project rent growth and cap rate stability/compression. These assumptions compound over the term of the underwriting and reflect in a very high sales price. 

In a tertiary market, if your growth and valuation assumptions are wrong, you still earned the bulk of your returns from dependable cash flows. In contrast, in a growth market where cap rates are very low, if growth doesn’t occur as expected and cap rates widen, there will not be much left in terms of positive returns. For example, we recently underwrote a property in Houston (a strong growth market, not tertiary), which we would need to buy for $56,800 per unit in order to achieve our desired returns of at least 15% IRR, assuming 2% rent growth and reasonable cap rate expansion (6.5% exit cap since the market cap rate for stabilized class B assets is around 6%). However, the asking price is not $56,800 per unit, but rather $68,000. At that price, we would have to assume 4.25% rent growth and a 6% exit cap rate in order to achieve the same 15% IRR. Even more detrimental is the fact that only 46.7% of the returns are coming from cash flow with rest relying on growth and a very large and optimistic sales price. In our $56,800 per unit and lower growth example, the percentage of returns coming from cash flow is 57.5%. The difference is not that great because the subject investment has a large value-add component but it is still a strong indicator of the investment’s downside protection. In tertiary markets, the returns from cash flow can be as high as 70% with cash on cash returns in the teens. 

An interesting takeaway of embedded growth assumptions is that things out of your control (rent growth and cap rates) must go right for you to earn your projected return in a primary market. On the other hand, those assumptions, which are out of your control, simply need to stay stable in a tertiary market for adequate returns to be achieved. This idea is also illustrated in debt service coverage ratios. In tertiary markets, it is possible to acquire property with a trailing DSCR of 1.50x. In major markets, I rarely see deals that can support 75% leverage with even a 1.10x DSCR. I’d rather take more market risk but be able to fully capitalize on max leverage at historically low interest rates and still have great coverage rather than buy in prime locations with numbers which are totally upside down. 

Speaking of leverage, financing used to be a difficulty of tertiary markets. However, today’s lenders have the data and technology to better understand smaller markets and get comfortable putting out debt capital at very favorable pricing. “Expanded market data analytics, like those provided by Trepp, EDR, Reis, and MetroStudy, provide capital sources the confidence to venture increasingly into secondary and tertiary metropolitan statistical areas (MSAs). Bottom line, without this technology, commercial real estate finance would never have expanded to the $4.1 trillion market it is today” (CCIM Report). The difference in cost of debt capital from primary to tertiary markets is more than made up for in the cap rate spread. Access to very cheap financing (4.5%) supercharges cash on cash returns in markets where cap rates are 7%+.  

By definition, most real estate deals and syndications are beta, or a reflection of average market pricing/performance. However, in primary markets the distribution curve of returns above and below beta is very tight. The peak of both graphs below is beta and results to the right of beta are outsized returns, or alpha. 

As you can see, in primary or more competitive markets, it is much more difficult to achieve alpha since pricing is very efficient. On the other hand, tertiary markets are less liquid and have less competition, which makes it easier to outperform (as well as underperform). This means that active managers have a greater impact on investment returns in less liquid markets where the range of outcomes is broader and they can use their research and expertise to beat the market.

One point to note about underwriting exit cap rates in higher cap rate markets is that cap rates must be widened more in order to achieve the same mathematical effect as the same nominal cap rate expansion for lower cap rates. For example, going from 4% to 4.5% cap rate represents an 11.1% decline in valuation. Meanwhile going from 7% to 7.5% cap rate is only a 6.7% decline in valuation. Therefore, higher cap rates must be widened more to achieve the same conservative effect. However, some tertiary markets actually offer a more stable cap rate environment than growth or “boom-bust” markets which argues cap rates do not need to be widened as much as they need to be in major markets.

Since the general market is so competitive, we would rather focus on opportunities where we can unlock idiosyncratic value or invest in tertiary markets which have lower projected rent growth but higher initial yields. We are listening to our investors’ worries of price stability and deteriorating asset performance and thus are seeking investments with healthy debt service coverage ratios and more downside protection. Downside protection can also be achieved through adjusting capital structure such as permanent senior financing or offering preferred equity.