Institutional real estate investment has long been associated with prestigious properties in major gateway cities. However, as the landscape of the real estate market continues to evolve and expand, investors are increasingly turning their attention to secondary markets. These “lifestyle” markets, often characterized by lower cost of living, an educated population and untapped potential, offer unique opportunities for investors seeking attractive returns and diversification. But how do you choose among a multitude of secondary or even tertiary markets? Real estate isn’t day trading. Investors can’t easily jump in and out of an investment if they choose wrong. So, what differentiates sustainable quality markets from those that are merely an interesting bet in the short term?
To begin with, a quality real estate market has both a strong demographic (i.e., a significant educated/skilled working-age population) and an economic growth story.
“Target locations usually have population and employment growth above the national average and a diversity of high value-add industries,” says Tim Wang, managing director and head of investment research at Clarion Partners. “Such markets typically have vibrant live/work/play markets, as well as a sizable institutional investor presence and depth of liquidity.”
In the past, these attributes have been found primarily in gateway cities. But, as remote work has seen workers move out of high-cost-of-living coastal markets, and as industry has embraced the advantages of hubs around the country, a growing group of previously second-tier cities has been attracting attention and institutional capital.
According to respondents in the most recent Emerging Trends in Real Estate survey, Nashville, Dallas/Fort Worth, Atlanta, Austin and Tampa/St. Petersburg are currently the most attractive U.S. real estate investment markets. Rounding out the top 10 are Raleigh/Durham, Miami, Boston, Phoenix and Charlotte. Although a few of the cities on this list are old standbys, notably missing are the gateway markets of New York City, Chicago, San Francisco, Los Angeles and Washington, D.C.
The focus is no longer on being big, but on having the capacity to grow. Cities that can attract and retain talent are more likely to meet this requirement than those that are losing population.
“Accessibility to skilled talent continues to be the most critical consideration, particularly given the increasing importance of retaining workers in a hybrid environment and reducing commute times where possible,” says Phil Ryan, director, City Futures at JLL Research.
Zeroing in on specific cities that are growing or have a highly educated and employed populace is a good first screen, but the questions then follow: What else separates a quality market from a flash in the pan? Is the growth being driven by factors that will continue long term? Will the city maintain its attractiveness to attractive workers?
To answer these questions, additional screens and overlays are added to the analysis.
Starting at a high level, investors look at the stability of the local economy. A sustainable investment market would be anchored by growth industries, and would typically include research, medical and educational institutions.
In addition, one of the themes running through the most attractive secondary markets is a lower business-tax climate and a relatively lax regulatory environment. Added to a welcoming business atmosphere, the towns typically offer a lower-than-average cost of living, as well as higher-than-average quality of life features (such as mild climate, cultural events, high-quality education facilities and recreational activities) that appeal to a wide swath of the population.
NEED FOR SUSTAINABILITY
Here, however, is where things get complicated. The very aspects of a market that allow it to fall into the “quality” category can also impact whether it will stay there. One of the main stumbling blocks to sustainable growth is infrastructure. Although low taxes are an incentive to locate in a market, the lack of capital to build out roads, light rail and other transportation options can constrain future expansion. Austin has become the poster child for a quality investment market with a transportation infrastructure struggling to support its growth.
“Infrastructure expansion is an essential ingredient in increasing the capacity of cities to handle growth,” says Ryan. “In Seattle, more than 32 miles of new light rail routes are under construction and will connect numerous densifying activity hubs such as Bellevue and Redmond. Best practices from abroad in cities with similar challenges, such as Paris, Sydney and London, have involved extensive integration of large-scale development and regeneration along new metro lines and using the value uplift to fund the cost of expansion.”
But it’s not just transportation that can hinder continued expansion.
“We’re also looking at connectedness,” says Maureen Joyce, managing director and head of U.S. real estate asset management and equity portfolio management at Barings. “We’re starting to look at which cities and states are taking advantage of the CHIPS and Science Act, as well as the Inflation Reduction Act, because there could be substantial capital that can support infrastructure improvements, including internet connectivity, to support long-term growth in a marketplace.”
Demographics is another area that giveth and taketh. The work-from-home model that was accelerated during the COVID pandemic saw cities such as Austin, Boise, Nashville and other lifestyle destinations grow as educated workers sought out a lower cost of living plus a better work/life balance. According to the U.S. Census Bureau, however, migration to smaller cities slowed significantly in fourth quarter 2022, while inflow or return to the large coastal cities picked up. Without the continued influx of high-quality workers, some of these high-growth cities could find themselves with an oversupply of housing and office space.
“It is crucial that all markets are consistently monitored for population growth, income growth, job growth, employment-to-population ratio [rather than unemployment], concentration of employers and industries and, of course, supply of new product,” says Jonathan Needell, president and CIO at Kairos Investment Management Co. “Of these factors, diversity in employment opportunities and industries — rather than a concentration of just one or two industries — can be a key indicator of resilience of both primary and secondary markets.”
Finding sustainable quality markets in secondary cities doesn’t mean that historic gateway markets are going away. There are certainly challenges such as high cost of living, high business costs (including taxation), housing shortages, heavier regulation and deteriorating urban cores, among other hindrances to investment. But they are big population centers with highly educated populaces, vibrant economic activity and a track record of providing returns in all types of environments.
“While gateway cities have been disproportionately affected by the COVID pandemic and subsequent changes to commuting, working and living preferences, they maintain substantial advantages that are unlikely to abate,” says Ryan. “Key to this is scale: of the 28.6 million people with a degree in science or engineering nationally, for instance, nearly 6.8 million live in New York, Los Angeles, Chicago, Washington, D.C., and the Bay Area. As a result, 23.8 percent of core STEM talent lives in metropolitan areas that represent just 16.4 percent of the United States’ population. Similarly, gateway geographies have extensive infrastructure and connectivity that will enable them to maintain significant influence and attraction for individuals and companies alike.”
Both gateway and secondary markets are also benefiting from a more nuanced view of what constitutes a market. Investors are no longer simply giving a thumbs up or down to San Francisco or New York City, but are looking at submarkets within those large, established areas, as well as within less established regions.
“Even in markets with relatively low levels of overall population gains, there are pockets of extensive development and investment, evidenced by the North Loop of Minneapolis and Culver City in Los Angeles,” explains Ryan. “This success builds on the ability to create places and capitalize on extant and growing institutional, research, health and cultural hubs, all while crafting a built environment that focuses on experience, accessibility and sustainability. ‘Destination submarkets,’ such as Fulton Market in Chicago, Shoreditch in London and RiNo in Denver, routinely command rental premiums of more than 30 percent and are registering occupancy growth even during a time of substantial disruption.”
In the past, investors have viewed secondary markets as a speculative play because they were considered too shallow to sustain growth during down times. Demand could fall quickly, resulting in oversupply. While that may still be true for some of today’s hot destination cities, others look to be the real deal.
“Population is more dispersed now than it has been in the past,” says Joyce. “Previously, if a recession hit, the secondary markets tended to find themselves oversupplied because employment and, therefore, demand slowed. Now, the demand factors are stronger than they have been in the past because people have moved in. Secondary headquarters have moved in. The rest of the economic drivers, such as access to capital, favorable business environment, high educational attainment, that keep a city or a location or market resilient are present. I do think they’re going to be more resilient than they have in the past.”
Pinpointing those markets with sustainable drivers that will withstand a downturn is, of course, the challenge. When everything is considered, much of the expected sustained growth is focused on the south or near more mature markets.
“Evaluating growth factors has led us to a current focus on what we call the ‘smile’ states,” says Needell. “From the Pacific Northwest, down through the Southeast, and up to the Carolinas are where these quality markets tend to be located. Many of the markets where we have been active have been suburbs of primary or gateway markets.”
The solution to finding quality markets relies on knowing what you are looking for. A quality industrial market might be very different from a quality tech market or hospitality market. And a struggling market today might be soaring tomorrow, especially if it has a history of bouncing back.
“We are looking at some gateway markets, as well as secondary markets,” says Joyce. “We are looking in San Francisco because falling valuations could result in an attractive acquisition. People are starting to move in. AI and other technologies are still headquartered there. It’s not the top of our list, but it’s still going to be an important market. Austin office vacancy is pretty high right now, but long-term we expect that to turn around. So, we are going to mix and match our investments among mature and growing markets. No single market can do it all.”
Gateway markets are not likely to hold the dominance that they held prepandemic. Technology has allowed the population to become more dispersed. People don’t need to cluster in the major cities to find jobs. They can migrate to places that have better quality of life standards. However, gateway cities are still going to be relevant. They’re still going to be important. They still set the standard for sustainable quality because they always seem to bounce back.
“Over the long term, the gateway cities or primary markets [i.e., New York; Boston; Washington, D.C.; San Francisco; and Los Angeles] will always remain attractive due to their historic track records and large employment bases,” predicts Wang. “However, we are currently more optimistic about the select submarkets and the surrounding suburbs of the gateways relative to the central business districts, which are struggling more with public safety, high living costs and traffic congestion.”
The landscape of institutional real estate investment is evolving as investors follow the population away from gateway cities in pursuit of more favorable opportunities and risk diversification. While gateway cities will always hold their appeal, emerging markets and secondary cities are increasingly becoming the focus of institutional interest. This shift is driven by a combination of factors, including pricing dynamics, diversification strategies, changing work trends, infrastructure development, demographic shifts and environmental considerations. As the real estate landscape continues to evolve, secondary markets are providing quality real estate investment opportunities for investors looking beyond the traditional boundaries of gateway cities.
Sheila Hopkins is a freelance writer in Auburn, Ala.