Institutional and large private investors have long concentrated their real estate investments in primary markets (such as Chicago, Los Angeles, New York and San Francisco), and in hot secondary markets (such as Austin, Charlotte, Denver and Phoenix). While they have done well with those locales over the years, those and similar markets have gotten crowded and expensive when real estate assets are performing well, begging the questions: How much money is being left on the table in tertiary markets? What are the challenges to investing in these markets, and how are they best evaluated and accessed?
Ryan Swehla is co-CEO and co-founder at Graceada Partners, a real estate investment firm focused on secondary and tertiary markets.
Investors are familiar with primary and secondary markets, but what defines an investable tertiary market?
A tertiary market generally has fewer than 2 million people in its metropolitan statistical area. Investable tertiary markets exhibit the same strong investing characteristics as primary and secondary markets: population growth, economic drivers and supply constraints. But they also exhibit relative affordability when compared with nearby secondary or primary markets. There has been a secular shift in where people live and how they work. A recent Wall Street Journal article noted that, on average, people are moving farther away with new home purchases than they ever have. This allows growing tertiary markets with affordability to become even more desirable. The western United States (excluding coastal California) and Florida have become the biggest winners for relocation by young professionals and high-income earners, according to two recent Smart Assets studies.
Why have tertiary markets been traditionally overlooked by investors? What’s the aversion?
Historically, institutional investors perceived tertiary markets to have a lack of scale and liquidity. The tertiary market segment represents trillions of dollars but is primarily private families and individuals in those markets or investing from primary markets. It is a substantial segment of the real estate universe but is largely non-institutionalized. Much like self-storage or single-family home rentals, tertiary markets are a mature and large segment of the real estate market but have yet to become institutionalized. We believe it’s inevitable that tertiary markets will become institutionalized.
Institutional investors have associated tertiary markets with a lack of liquidity because historically they attempted to access these markets by deploying at institutional scale and purchasing the largest assets in the markets. This inevitably leads to lack of liquidity. Effectively accessing these markets requires buying smaller assets ($10 million to $50 million) in the liquid middle of the market. Consequently, it requires a highly disaggregated strategy to achieve both scale and liquidity — much like self-storage or single-family home rentals. How to invest in tertiary markets is as important as where to invest.
What investment opportunities exist in the best tertiary markets?
These markets are ripe for institutional sophistication and strategies. It is not hyperbole to refer to tertiary markets as the Wild West. Many strategies readily and broadly deployed in primary markets — such as dynamic rent pricing, energy efficiency retrofits, green audits and utility reimbursement — are virtually nonexistent in tertiary markets. The ability to generate excess return utilizing readily available strategies is significant. Opportunistic returns can be generated with a very conservative value-add strategy. It doesn’t require trading risk for return since tertiary markets are simply unsophisticated and inefficient.
What are the challenges to investing in these markets?
The biggest challenge in inefficient tertiary markets is developing market knowledge and relationships. While research and data are readily available in primary markets, it is virtually nonexistent in tertiary markets. This is why a “helicopter” scattered approach can incur much greater risk in tertiary markets. Going deep versus wide is critical for developing market knowledge and relationships. It allows savvy investors to cultivate a pipeline of off-market acquisitions (a property that was never marketed or listed for sale), something almost unheard of in hyper-competitive primary markets.
How are tertiary markets best evaluated and accessed?
Tertiary markets are successfully evaluated by identifying clusters that exhibit long-term positive population growth (secular demand), low vacancy (supply constrained), and relative affordability in both acquisition price and market rent (runway for growth in rent and value).
There are two ways to effectively access tertiary markets. First is to develop personal knowledge and conviction around specific markets and go deep, not wide, into those markets. This allows one to develop proprietary market knowledge and relationships in those markets. Second is to work with a group that understands and invests in those markets.