As pension funds, life insurance companies, and REITs grow increasingly anxious to place capital, the pent-up demand for core assets in the highest-barrier metros isn’t likely to go away any time soon.
The bidding wars and resulting cap rate compression in primary markets last year drove many multifamily investors to look beyond primary markets for higher yielding opportunities. But increasing your risk tolerance by looking toward secondary and tertiary markets can be a tricky business. Here are six tips to keep in mind.
Tip #1: Focus on management.
When Raintree Partners acquired Boulder Creek Apartments in Riverside, Calif., last year, it treaded cautiously given the state of the local market. The Inland Empire was one of the hardest-hit areas in the nation in terms of single-family overbuilding and job loss. When underwriting the deal, the company knew it couldn’t cut corners for a third-party manager. “We made a point of paying a top-end salary to get a high-end on-site manager in Riverside,” says Aaron Hancock, director of acquisitions for Laguna Niguel, Calif.-based Raintree. “We wanted to make sure we had one of the best people in the market, so we budgeted for it.”
Tip #2: Be patient.
Investing in many tertiary markets requires having long-term vision. You can’t depend on meaningful rent growth to generate returns—the focus instead should be on cash-on-cash returns. “Make sure you use a capital structure that allows you to be there for the long term, so you can wait out a cycle,” advises Raintree’s Hancock. “You need long-term debt and patient long-term equity.”
You also can’t depend upon a disposition. “We’re in it for the long haul, but we need to know that we can get out in a reasonable amount of time,” says David Gardner, CFO of Rochester, N.Y.-based Home Properties. “You might get a good return on the asset you’re holding, but in a tertiary market, a sale is certainly not a given.”
Tip #3: It’s all about the submarkets.
Most market research paints markets with a very broad brush—average rents and average occupancies—without breaking that data out by asset class or submarket. “What they’re doing is generalization,” says Jonathan Holtzman, chairman and CEO of Farmington Hills, Mich.-based Village Green Cos.
Village Green will break ground later this year on a 156-unit, 11-story development in Ann Arbor, Mich., which is about 40 miles from Detroit. The local market there is strong, driven by the local university, biomedical research, and the resurgent automobile industry. “Macroeconomics say don’t do anything in Michigan,” Holtzman says. “But microeconomics will tell you that some Detroit markets are among the best in the United States today.”
Tip #4: Question the hype.
The data provided by market research firms really only goes so far. It’s best to err on the side of caution. If the research is spitting out numbers that appear too good to be true—whether for a primary, secondary, or tertiary market—they probably are. “We’re underwriting a deal right now in a market where one of the data sources are projecting 6 percent market rent growth per year through 2014,” says Mike McNamara, head of acquisitions for Philadelphia-based TRECAP Partners. “We’re underwriting about half of that.”
Tip #5: Do your homework.
The most important thing when entering a new market is to do exhaustive research—find out everything you can, and then find out more. Partnering with experienced local operators that know the market inside and out is also a good rule of thumb. When Raintree entered Riverside last year, it was very concerned about the shadow market of unsold condos and single-family homes. And no data provider keeps any good stats on this segment of the market. But in canvassing all the local rental listings on Craigslist and Realtor.com, Raintree found that the amount of condos and homes for rent in a 1-mile radius of its asset numbered just 10.
Tip #6: Look for stable employment centers.
Secondary and tertiary markets are much more sensitive to the loss of a major employer. “The risk in a tertiary market is that it might be limited to three to five major employment centers,” says John Smith, chief investment officer at Home Properties. “So even if you’re buying at an initial great yield, the resale value may not be a heck of a lot more five or 10 years out.”
The other side of the coin is that smaller markets reap larger rewards when a major employer moves there. For instance, in Malta, N.Y.—25 miles north of Albany—Advanced Micro Devices is developing a $4.2 billion semiconductor manufacturing plant, and is requiring many of its suppliers to relocate to the area, creating thousands of new jobs in the area. “Albany is a secondary market on a good day,” says Eric Silverman, founder of Newton, Mass.-based equity investor Eastham Capital. “But when a big player comes in and spends billions making a silicon wafer plant, and along with its suppliers will employ 10,000 people, we’re going to rent some apartments.”
