Real Estate Investment in Tertiary Markets: Bullish Trends To Monitor
When I began my commercial real estate career, the term "tertiary market" always had an unappetizing undertone. I always considered real estate investment in small cities to be a mirage. Higher returns and lower prices per unit could lure investors to smaller markets on paper.
However, as soon as there was an economic downturn, I figured multifamily assets would get crushed by high vacancy rates and declining rent growth brought on by the hard times. On the other hand, the larger urban/suburban areas' investment properties could hold serve and weather the storm buoyed by job growth, larger populations, and more demand from both renters and investors.
Contents
Tertiary Market Definition
Defining what is a tertiary market is subjective. A multifamily investor in New York City may look at a property in Austin, Texas, as a tertiary investment opportunity. A serial investor in Austin, Texas, may view their home market as the primary market and a city like Victoria, Texas—home to about 67,000 residents and two hours southeast of Austin—as a tertiary market.
I'll often talk to investors from the Bay Area who consider Minneapolis, Minnesota, to be tertiary. It's all relative.
Primary vs. Secondary vs. Tertiary Market Real Estate
There is a generally accepted high-level classification of markets. On a national scale, primary markets are your major employment hubs and tend to gravitate towards the coasts. Think:
New York
Los Angeles
San Francisco
Boston
Secondary markets will also be densely populated cities but not nearly to scale as listed above. Think:
Chicago
St. Louis
Phoenix
Denver
Las Vegas
Tertiary, to me, isn't the major employment hub of any state, nor is the surrounding metro area (typically classified as 1st ring, 2nd ring, and 3rd ring suburbs).
My definition of tertiary is:
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
Some common characteristics of a "classic tertiary market" will be a major thoroughfare that makes the city accessible. There could be a highway that cuts through town or is nearby. Many tertiary cities often host a medical center or university that provides the most employment. Or there could be one large employer that supports the vast majority of the community.
These traits aren't required for a town or city to be considered "tertiary." Still, they're common characteristics I've noticed, especially in submarkets ripe for real estate investing outside of the "big city" limits.
Tertiary Real Estate & Covid
The onset of Covid 19 dealt the real estate industry a significant obstacle in 2020. I saw a stretch where value-add opportunities were all but dead in the eyes of most investors. Vacancy, bad debt, and uncertainty about stimulus measures weighed heavily on the last decade's most popular multifamily investment strategy.
Investment activity stalled out, sales volume plummeted, and everyone seemed terrified about the future.
In late summer, I noticed a nice uptick in investors getting "back to work." It seemed like there was a comfort level with the pandemic, and real estate investment was again a significant emphasis. Since Q3 2020, I have been analyzing apartment buildings nationwide, often in smaller cities. I want to share my observations with you.
I've unearthed some very bullish trends at these properties that have not been prevalent in many urban (core real estate market) deals I have analyzed. It will be up to real estate investors to determine if this is a fad or a sustainable trend.
Seven Encouraging Tertiary Market Trends
Let's get into the seven exciting trends I've uncovered in tertiary markets nationwide.
High Cap Rates and Yields
To make sense of buying property (of any asset class) in a tertiary market, you must solve for a higher risk-adjusted return than in the big city (in the form of a cap rate). The same held in 2020, but what felt different was that many other fundamentals appeared more favorable than in more populated submarkets. Amid an economic setback, tertiary held up just fine. The softest markets I've experienced were urban. Returns looked sweeter on tertiary deals with solid historical financial trends, a vital rent roll, and solid labor statistics.
Strong Occupancy
It's surprising how stable the occupancy was on every tertiary deal I reviewed in late 2020 and early 2021. Most were 100% occupied, and I can't think of an instance where occupancy was below 97%. A lot of this had to do with the rent's affordable nature. Even if there was cheap housing for sale, the projected monthly payment was still much higher than renting a 1BR or 2BR apartment. Eviction moratoriums could have affected this in some capacity, but I did confirm that unpaid rent was not a significant hindrance.
Employment Trends
I always compare a tertiary city's employment metrics to the overall state and more prominent metropolitan hubs. Perhaps the biggest shock was how gross employment in many tertiary cities had improved post-Covid. While large urban centers grappled with stagnant employment numbers and drop-offs in the labor force, many tertiary towns not only recovered from the brunt of COVID (spring of 2020) but improved! The labor force also increased, which bucked the national trend during that period!
Favorable Property Tax
Property tax is the most burdensome expense for property owners in populous counties. Plus, if you purchase a property for a price beyond the current county assessment, you'll typically see the property's assessment jump to the sales price in a matter of years, creating even more property tax liability.
This danger is not as prevalent in tertiary counties. Often, there isn't enough sales volume for an assessor to tag a sale and say, "Whelp, this is the new assessment in the future." Many states have laws that explicitly state that "one sale does not constitute the market." There must be adequate evidence of multiple sales exceeding current assessment levels before a significant increase can occur.
Paying beyond the property's assessment in tertiary markets isn't a death sentence like in high-volume transaction markets. A 2%-3% escalator post-sale may be the extent of the property tax increase. Research this on your own and verify property tax comps. Calling the local assessor is never a bad idea.
Ma & Pa in Decline
Everyone is always looking for "Ma & Pa" operators who lack sophistication, are tired, and want to sell their property and retire in Florida. Tertiary markets have an abundance of these operators. Get comfortable with forgoing the nicely curated T12 and rent rolls you will receive from the institutional investors, and brace yourself for the PDFs, tax returns, and incomplete financials with a hand-written rent roll on a post-it note. Opportunity is often abundant once you realize what has been neglected at these properties.
Many buildings won't even have a property website. Imagine what an Apartments.com account or free advertising with aggregators like Zillow would do for their leasing business. You may even notice that the competition doesn't have websites when doing your rent comp analysis! Remedial internet skills would reap massive gains in many tertiary markets countrywide.
Expense Cuts/Utilities
Expenses were usually out of whack, and in my opinion, fixes were simple. The biggest culprit of expense run-up was water expense! Plumbing fixtures were leaking, and ownership hadn't inspected the units to find the source of the problem. Energy efficiency is an afterthought for many property owners in smaller cities. Making green improvements could save a boatload in expenses and bode well with a lender that may offer green incentives.
Tertiary Market Obstacles
Assuming you found the perfect property that provides an abundant opportunity, there still would be obstacles to overcome. Some of these include:
Management
Who would handle the day-to-day property management if you lived over an hour away from the property? Would you hire a reputable 3rd party manager? Would you be willing to drive to the property to handle an emergency? Would you depend on a caretaker? You'd need to iron out management before anything else.
Financing
You'd need to find a lender that is comfortable with smaller cities. Debt may be more costly with lower leverage as banks may need to hedge for riskier investments. Agency lenders may not touch tertiary properties, especially if they're distressed or offer max leverage of 55%-60% of the value.
Complexity
I've found that many properties are encumbered with affordability mandates. It likely only made sense to develop these properties initially with outside funding that stipulated keeping units affordable. The affordability requirements tend to be close to the actual market-rate rents, so rent growth isn't an issue. You must research what it takes to maintain compliance, which could mean additional administrative expense and time to understand all the components.
Summarizing Tertiary Markets
Tertiary markets are towns that exhibit:
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
Bonus points if there is a college, medical center, or large government employment base.
I believe there is an opportunity to invest in tertiary real estate markets around the U.S. as long as the labor fundamentals remain strong. I am more bullish than ever, seeing how these assets have coped with COVID and continue to thrive when urban assets have sputtered. Suppose you can find a tertiary opportunity and determine the management, financing, and nuances with potential affordability requirements. You may set yourself up for a prolonged period of outsized investment returns.
