By Scott Lynn, Director/Principal

Availability of capital is a key determining factor when it comes to investing in secondary and tertiary markets, according to a survey conducted for National Real Estate Investor (NREI), Retail Traffic Magazine and Coldwell Banker Commercial.*  Investors and developers are going to secondary markets seeking better returns, greater value creation and less competition. The downside is that capital is often scarce, the exit /sale market is not as wide, cap rates are higher and the prospective tenant market may not be as deep.

Since the financial crisis began along with what seems to be the Never-Ending Great Recession, Investors have flown to quality by pursuing the “Best of the Best” in core market assets. The competitive environment has correspondingly pushed down investment yields and Cap Rates. Meanwhile, yields on assets in non-core and perceived to be secondary or tertiary markets have not compressed although occupancies have improved.  New development activity, however, is practically nonexistent in these types of locations.

The NREI / Retail Traffic / Coldwell Banker Commercial survey collected data from 194 developers, owners and managers from May 12 to June 6, 2011.  Respondents own and /or manage an average of 1.4 million square feet of commercial real estate in secondary and tertiary markets.

Key findings from respondents include:

  • 46% reported vacancy rates of less than 10%.
  • 45% expect to achieve increased rental rates in 2011.
  • 44% expect to make additional investments in Non-Core markets in 2011.
  • Over 50% will make upgrades and capital improvements to their portfolios.
  • Respondents have seen average Cap Rates of 8% to 12.5% in non-core markets.
  • The strength of the local economy and availability of financing were the two most important factors when considering an investment.

Retail Traffic Magazine* highlighted the comments of Mark Stapp, a real estate developer and executive director of the Master of Real Estate Development program at the W.P. Carey School of Business at Arizona State University, who made the point that perception often plays a greater role than reality when it comes to investing in smaller markets.  “Lenders and Investors haven’t studied the markets enough to know the real risk, so it’s easier to just say ‘NO,’” he explained.  “Sometimes the reasons why an investor won’t look at a particular place have nothing to do with market fundamentals.”

With minimal Cap Rate compression and less competition, Investors, Sponsors and developers are appropriately chasing yield in non-core markets. Add the extra benefit of historically low interest rates for both short-term and long-term debt and you have the makings for attractive leveraged equity returns, if you are able to source capital in these markets.

Getting Lenders and equity investors to go to secondary or tertiary markets is not an easy task. At Metropolitan Capital Advisors (MCA) our motto as finance intermediaries has always been, “We will work on the deal if we can get to the property within two hours by car or plane.” Lenders and Investors usually won’t even consider leaving their desk if the SMSA population is less than 500,000, which rules out tertiary markets almost altogether. But there are exceptions to every rule. Our firm recently placed a $12,725,000 loan with a 4.8% fixed interest rate for two apartment properties in Tulsa, OK.  There, the story was more about the strength of the local economy than it was about the population. Tulsa, with a population just under 400,000, continues to create jobs as evidenced by the unemployment rate of only 5.8%!

MCA recently placed a $19,600,000 debt and equity package during spring  2011 on a to-be-renovated mall in Columbus, OH, that was being acquired from the Lender who had foreclosed.  MCA successfully got Lenders and Investors over their initial hesitation to consider a deal in Columbus by pitching a favorable story about the strength of the local economy, along with focusing the capital providers on the fundamentals of the real estate deal itself, such as:

  • The property was being acquired at a “distressed” price resulting in a favorable cost basis.
  • The location was “Main & Main” with barriers to entry.
  • The Sponsor was a local player with deep market knowledge and proven retail expertise.
  • The Sponsor was willing to “co-invest” a significant amount of the equity, allowing the transaction to be under-leveraged.

So what did it take to get the deal placed? MCA approached over 50 separate equity sources currently focused on distressed retail opportunities to come up with four or five prospects that would even consider a property in a secondary market such as Columbus. Interestingly enough, the debt placement was even tougher with over 70 Lenders prospected before a West Virginia bank quoted the requested terms.

Regional and local banks are often a logical source of debt financing in secondary markets.  However, Borrowers are best served by searching the capital markets far and wide, as was the case for Ashley Plaza Center in Farmington, NM, where MCA secured a ten-year fixed rate loan from a CMBS Lender who took the time to understand the local economy and limited retail competition that was driving phenomenal sales at the property.

If you are going to chase yield in secondary markets, be prepared to undertake herculean efforts to get your deal done. If you are in a tertiary market, be prepared for an even more arduous challenge.  Just understand that most capital providers will have an aversion to stepping outside the box. The real challenge is beyond just stepping outside the box but rather, getting capital to step into the car or onto the plane for that two hour ride.

Want to learn more, contact Scott Lynn, Director / Principal.

*Source:  Retail Traffic Magazine, “Beyond Core Markets” Sept/Oct 2011