The New Question May Be Whether Rising Popularity of Second-Tier Markets Among Investors Is Sustainable As Interest Rates, Borrowing Costs Begin to Rise Again
The sale of a small shopping center in Salinas, CA, more than 100 miles south of San Francisco but a world apart from the cosmopolitan Bay Area market, would hardly rank as a bellwether transaction for the U.S. or even the Northern California real estate market.
HFF managing director Nicholas Bicardo, who headed the team representing the seller in the sale of the 93,796-square-foot Boronda Plaza, private REIT Donahue Schriber, described the transaction this way, however: "An excellent opportunity for the buyer to acquire a dominant grocery-anchored retail center located in a secondary market in Northern California at a very attractive yield comparatively to primary markets."
"Given where spreads are on [capitalization] rates between primary and secondary markets, we are seeing a tremendous amount of capital migrate to similar markets like Salinas in search of higher yields," Bicardo said.
Many investment analysts have reached the same conclusion. With the economy continuing to strengthen in fits and starts, more opportunistic investors - in many cases priced out of the top coastal markets like San Francisco, New York City and Washington, D.C. -- are seeking higher yields in secondary markets where job growth and business conditions have accelerated during the economic recovery.
The 10 metro areas adding jobs at the fastest clip over the past 12 months include not only the perpetually hot Texas technology and energy markets of Austin, Dallas/Fort Worth, Houston; and California’s Silicon Valley, but also less obvious choices like Nashville and Salt Lake City -- and even surprising dark horses such as Indianapolis, Phoenix, and Jacksonville and Tampa, FL, noted Robert Bach, national director of market analytics for Newmark Grubb Knight Frank.
Debt capital also is following investors to these locales, said Tal Bar-or, managing director for Meridian Capital Group, who has noted an uptick in secondary and tertiary market lending in recent months.
"Lenders are being more and more aggressive in entering new markets, following borrowers seeking opportunities outside the typical core of New York, D.C., San Francisco," said Bar-or. "Investors are willing to assume more risk to add and capture value and reap upward yield, even in an environment of concern over rising interest rates."
Spreads on mezzanine debt backed by equity on core assets in top coastal markets have compressed significantly in recent months,
forcing portfolio managers further out on the risk curve to deliver promised yields.
“Money managers who promised investors 10-12% returns are being priced out of major markets, and they’re having to provide smaller mezzanine [tranches] in secondary markets to achieve those kinds of returns,” said Dustin Stolly, a mortgage banker and executive vice president at Jones Lang LaSalle.
Now may be the time for many investors to start considering assets in secondary markets, especially those interested in value-add plays, noted Jeff Myers, senior real estate economist with CoStar's Property and Portfolio Research (PPR), commenting on the hotel investment market. "With distress shrinking and investors focusing on relatively safe assets, in top core markets, price points often rival mid-2000s highs. And the share of overall volume in these typically fundamentally superior metros remains above the long-term trend."
The emerging new story in the choice between primary and secondary markets, however, may be the rising cost of debt and interest rates over the last 30 to 60 days, said Dave Karson, executive managing director of Cushman & Wakefield Sonnenblick Goldman, LLC.
"For a lot of this year, prices for core and cash-flowing assets were bid up so high in the primary markets that there wasn’t enough delta between cap rates, and you couldn’t generate any cash-on-cash yield," said Karson. "Markets like Houston, Denver and Seattle all of a sudden became some of the most investable cities in the world on some people’s lists."
Hoping Rates Don't Rise (Too Much)
"Now, the question is, will investors continue to go to secondary markets, given that they can’t get the delta, that spread between debt and cap rates?"
Karson believes core properties in secondary markets will be less impacted by any interest rate spike because they can still get financing from insurance companies and banks, as their rates haven't jumped as sharply as in the capital markets and conduit lending world.
"The balance-sheet lenders are still providing financing that hasn't spiked that much, but it's only available for, or near, core properties," he said.
The most important factor for core-plus and value-add investors is the run up in 10-year Treasury rates, agreed Steve Pumper, executive managing director of Transwestern’s Investment and Asset Services Group.
In the heated Dallas and Houston markets, the question is whether investors are willing to step into the Nashville, St. Louis, Indianapolis or Minneapolis markets to achieve that added spread and maintain deal flow, Pumper said.
"Placing equity has been very competitive over the last couple of years, and as a result, there are only so many fully priced core deals that have come to market, and a lot of those are all-cash buyers," he said.
Some investors have responded by increasing their locational risk, while others are taking on more fundamentals and leasing risk, opting to buy better leased up buildings in the suburbs of core or secondary markets.
The major providers of institutional capital in the top markets will continue to do so, while their competitors will look for alternative strategies for placing capital, continuing to benefit high-growth secondary markets, Pumper added.