Three Types of Real Estate Markets

In the age of real-time news feeds, live streaming, and 280-character tweets, we as a society want our information quick and condensed. The side effect is that we tend to simplify and generalize complex issues.

So when news started trickling in this summer that major real estate markets across the country saw real estate values decline from 2018, investors became concerned. If real estate values and cap rates in San Francisco, New York, and Boston are being squeezed, then every other market must be experiencing the same phenomenon, right? Not exactly.

For experienced real estate investors, not all markets are created equal.

To the experienced investor, there are three types of real estate investment markets – primary, secondary, and tertiary – separated by population, demographics, and job growth. To categorize real estate markets solely by population would be an oversimplification and a mistake.

To the experienced investor, what happens in the primary markets doesn’t necessarily carry over to the secondary and tertiary markets. So, as cap rates and profits get squeezed in primary markets, the same may not hold true in secondary and tertiary markets.

But how do I know what market I’m working with? Here are simple explanations of the three types of real estate markets.

Primary Markets. Primary markets (aka gateway markets) – including New York, Los Angeles, Chicago, San Francisco, Boston, and DC – are centers of long-established commerce and population. They are also the focus of intense investment and competition by some of the most significant private equity funds, REITs and foreign investors in the world.

Secondary Markets. Secondary markets, or non-gateway cities, including Houston, Portland, Raleigh-Durham, Salt Lake City, Atlanta, Charlotte, Dallas/Fort Worth, Nashville, Denver, Miami, Seattle, and Austin offer the amenities of the primary markets without the dense population. Populations typically range from 1-5 million, and these markets have recently experienced surging populations and booming economies.

Tertiary Markets. Tertiary, or emerging markets, have steady but controlled job growth, populations typically under one million people, and a combination of traditional and alternative economic drivers.

Those who read the headlines about shrinking cap rates in the primary markets and assume opportunities have passed in all markets are missing the forest for the trees.

Primary, secondary, and tertiary (i.e., high-growth) markets differ in their populations and demographic makeup. However, by their very natures, their commercial real estate markets also differ and react very differently to economic shifts.

Cap rates in primary markets continually lag the cap rates in high-growth markets despite their ability to command higher rents. Cap rate compression in primary markets is a product of intense competition by the Blackstones of the world and deep-pocket foreign investors.

Want proof? According to real estate research firm CoStar, commercial real estate cap rates in the gateway markets of Boston, NYC, DC, Chicago, San Francisco, and LA have fallen to a range between 2-4%, down from peaks of around 4-6% in recent years due to increasing institutional and foreign competition.

Ignored by many institutional and foreign investors, cap rates in high-growth markets have not seen the same compression, holding steady between 5-7%.

High-growth markets don’t act like primary markets because their demographic and economic makeups are different.

High-growth markets are less volatile in downturns, and bargains in these markets can still be found with deals that are not overvalued and offer higher returns. They also offer stronger growth potential due to a lower cost of living and less supply.

High-growth markets are less volatile in downturns because businesses and residents flee from primary markets to markets seeking lower rents and leases – benefiting the real estate market in those areas.

This migration has already begun with a workforce attracted to these high-growth markets for the lower cost of living and higher quality of life, with typically better tax and regulatory environments more friendly to businesses.

Migration from gateway markets has led to corresponding job gains, which have led to steady increases in commercial real estate rental rates.

According to researchers at the Apartment Guide, the ten cities with the highest rent growth in 2019 were:

1. Sacramento, California
2. Fort Worth, Texas
3. Long Beach, California
4. Cleveland, Ohio
5. Albuquerque, New Mexico
6. Fort Wayne, Indiana
7. North Las Vegas, Nevada
8. Anchorage, Alaska
9. Stockton, California
10. Newark New Jersey

There is not one primary market listed in the bunch.

For commercial real estate investors, another appeal of high-growth markets is the value-add opportunities that still exist that you don’t see in gateway markets.

One sector of particular appeal is the multi-family sector. In the years since the Financial Crisis, multi-family is the one segment where supply has not caught up to demand.

Just like high-growth markets differ from primary markets, high-growth markets also differ among each other. So, when considering investing in a high-growth market, it’s essential to examine the merits of each market on their own. Some critical steps to take include:

1. Analyze individual characteristics present in the market.
2. Look closely at job growth at the local level, not the national level, to base your investment assumptions.
3. Don’t consider traditional economic drivers alone. Look at unique local economic drivers like Cannabis in Denver and shale in Mountrail County, North Dakota.
4. Look at 10-year cap rate windows, not just the immediate past for a better idea of a long-term outlook.

For qualified investors, significant opportunities exist for investing in private funds focused on high-growth markets. Private companies offer advantages large private equity funds can’t including:

1. Investment in high-growth markets.
2. Small and agile operations make critical decisions.
3. Lower Fees.
4. Lower overhead.

For those interested in investing in multi-family in high-growth markets, consider a private fund with a finger on the pulse of these markets.

Take control of your portfolio and invest with intention.

Kyle Jones