Best (& Overlooked) Real Estate Investment Class

Nov 19

I'm fortunate to work with investors covering all spectrums of the multifamily asset class. Beyond rental properties, I occasionally evaluate other commercial real estate assets such as industrial, office, and retail. With the abundance of investment packages I've seen over the past year, I am excited about a specific property type that stands out.

Best Real Estate Investment Opportunity

Newly Constructed B+ Multifamily in Tertiary Markets

I think of a tertiary market as the following:

At least a 1-hour drive from a major city
Less than 100,000 residents (often 50,000 - 75,000)
More than 25,000 residents (excluding extreme rural communities)
Not dependent on primary or secondary markets for employment opportunities

I describe tertiary much more thoroughly in this article.

I've seen it repeatedly—the best markets for real estate investing are often outside of major metropolitan areas and outperform more urban, infill locations.

Here are seven reasons why I think newly constructed B+ assets will thrive in outstate markets over the next decade.

Cheaper Land Basis = Functional Finish Levels

The land is much cheaper once you get outside the major metropolitan statistical areas. When land is more inexpensive, the real estate developer will have a much lower investment basis.

The cheap land is a big reason they can target "B" to "B+" finish levels instead of the pristine "A+" finishes you'll often see in the cities. In the cities, developers are forced to implement the finish levels that justify the highest possible rents. In the outstate markets, the incomes of the residents wouldn't support the fanciest materials, and developers can target much more modest amenities, including:

Detached garage parking
Laminate countertops, black appliances, hollow-core doors, and other builder-grade finishes
Limited community amenities

Essentially, you have a brand-new building that doesn't have all the frills you'd be accustomed to seeing in the cities.

From an investment perspective, this allows the developer to sell the investment property for less, make a nice profit, and leave meat on the bone for the subsequent real estate investors to cash flow nicely.

Stickier Resident Base

The job market post-Covid is forever changed. Many employees historically tied to an office job can work anywhere in the world with a laptop and internet connection. This trend could be worrisome for new developments that cater to white-collar employment centers.

I've noticed that the employment pool in tertiary markets is much stickier. Many of the jobs are more blue-collar in nature, and remote work isn't feasible. Prevalent industries include:

Manufacturing
Trucking/Distribution
Grocers
Healthcare
Education (Universities)
Government

Many of these communities are thriving. The pandemic had minimal impact on the labor force even when shutdowns peaked in the summer of 2020. Even more impressive, most apartment buildings saw low vacancy and minimal bad debt (unpaid rent).

Residents tied to geography are generally an excellent attribute of multifamily investment. I can't think of many instances where this is more prevalent than in outstate markets.

No Upfront CAPEX Budgeting

The value-add asset class (class B and C) has been the dandy investment strategy over the past decade. Improving units, common areas, and deferred CAPEX has generally increased rental income.

The value-add playbook is more challenging than ever to execute. There are severe labor shortages, all while the cost of materials is ballooning. Value-Add investment opportunities require more than some simple know-how from the property manager. It's now a significant logistical feat that may depend on some luck.

The beauty of new construction is that CAPEX requirements are minimal. The finish levels are modest but will not need any heavy lifting. Deferred maintenance should be non-existent with a property only a few years old. CAPEX budgeting is likely $200 - $300 per unit annually, with little or no upfront raise.

Less Investor Competition

There is less competition in tertiary markets. Many larger investment firms have stubborn investment committees that won't feel comfortable allocating money into a real estate market that lacks significant employment centers.

They may also be sensitive to the lack of liquidity in these markets when selling the asset (correlating with a higher residual cap rate). Less competition means more investment upside.

For buy-and-hold investors, the passive income of these assets can prove attractive compared to investing in the stock market, mutual funds, real estate investment trusts (REITs), or other public offerings.

Favorable Property Tax Reassessment

The riskiest operating expense to underwrite is real estate taxes. In counties that see high sales transaction volume, it's almost certain that the property assessment will increase to 85% to 100% of the sales price in future years.

The good thing about smaller markets is that sales volume is also minor. In many instances, the local assessor isn't allowed to "consider one sale as the market." There needs to be evidence backed by multiple apartment sales that could justify a higher assessment of the apartment stock as a whole. This evidence can be hard to come by.

In the populated urban centers, paying above the assessed county valuation is almost certain to justify a massive property tax bill in two to three years. The sale may have minimal impact in more rural counties, and property taxes will likely stay in line with other comparable properties.

Research this on your own. Calling the local assessor to learn how a property sale could affect future county valuations is never a bad idea.

No Lease-Up Risk

Development is risky in any setting. It could be argued that it is more challenging to lease up in less densely populated communities that don't have the deep renter pool of large cities. Purchasing a property that is fully stabilized takes many risks off the table. The developer has already proven the demand for the asset, and you won't need to rush to fill up units and avoid months of negative cash flow.

Favorable Financing Terms

Many industry players assume lenders aren't interested in mortgaging properties in smaller cities. This notion is false. I've seen loans with competitive interest rates, long interest-only periods, and non-recourse for borrowers.

If the property is distressed, that may be a different story. However, I'm discussing fully stabilized new "er" construction in decently populated tertiary markets. Opting for a larger down payment to lower the monthly mortgage obligation is enticing for individual investors looking for a solid cash-on-cash income stream.

Disadvantages

With any set of pros, one must always consider the cons as well. There are a few that come to mind.

Homeownership Cheaper

It's important to remember that the for-sale housing stock is also cheaper in low-cost living areas. Furthermore, financing programs may allow renters to transition to homeowners with as little as 0% down (see USDA loans). It's vital to keep rent growth assumptions reasonable when underwriting apartments that cater to residents with solid jobs that could potentially buy a single-family home as their primary residence.

Tax Benefits

Because properties are newer, there likely won't be any CAPEX spending, and properties would probably forgo a cost segregation study. Accelerated depreciation would be unlikely. This asset class isn't as suitable for investors who depend on depreciation and other tax benefits in their investment portfolio.

Developable Land

The barrier to entry of land development will be much lower than within the city limits. Usually, more land means more risk that apartment units are continually added during your investment hold. It's essential to understand local politics and the local appetite for adding housing stock. Ensuring your purchase price is at or below the replacement cost is crucial.

Spotty labor and increasing material costs (especially lumber) help make purchasing below "replacement cost" more feasible in the current economic environment. However, this trend may reverse over time.

Liquidity

Less competition is a benefit going into ownership but could backfire on the exit. There may be fewer qualified buyers to purchase the investment when the time comes to sell. In a scenario where the property is distressed, the outcome will likely be painful for the investors.

Summarizing the Best Real Estate Investment Opportunities

Overall, investment in B+ properties in tier III markets could offer a better risk/reward profile than popular infill value-add investment strategies or ground-up construction and provide more lucrative returns.

This article opines only on the high-level characteristics of this asset class. It would be best to verify that the return metrics are sufficient and that the submarket supports your proforma assumptions.

If you've historically invested in one asset class, putting some money to work in tertiary submarkets could be an astute diversification play.