In the search for higher yield, investors have started going further outside of the 4 major Texas MSAs of Houston, DFW, San Antonio, and Austin.
In 2007, there was a 50bps average apartment cap rate spread between primary (6.0%), secondary (6.5%), and tertiary markets (7.0%). In 2008 and 2009, the spread between primary and tertiary markets widened to almost 300 bps as investors flocked to core primary markets. In recent years, the spread between primary and tertiary markets have started compressing closer to the 100 bps we saw in 2007. Is this the new normal or is this foreshadowing of an upcoming correction?
In this post, I am going to discuss some of the advantages and disadvantages of secondary and tertiary market investing and some recent market activity.
- Higher yield on in-place income- Current cap rates are 50bps to 100bps higher depending on how far away the property is from the 4 large metros in Texas. As soon as investors do not get paid for driving 1, 2, 3 hours away from core markets they will stop investing in these markets.
- Less competition- Many investors are fighting over the same inventory in major metropolitan areas thus prices are getting bid up higher and higher on listed deals. Even on listed properties in secondary markets there is less competition. Secondary and tertiary markets will almost always be dominated by local and regional buyers’ not institutional capital.
- Limited new supply- DFW has over 30,000 units coming on line this year. In secondary markets, the financing is more difficult for new construction and thus there is very limited new deliveries.
- Less diverse employment base- In secondary markets, there is usually one or two dominant industries or employers which can severely impact occupancies in the event of a plant closing or a company consolidation.
- Limited lending options- Banks like to lend in their “backyard” so where they take in deposits and can drive to in a reasonable amount of time. There are typically less financial institutions in these markets, thus the financing terms you receive might be lower leverage (65%-70% vs. 75%-80%) and higher pricing (5.25%-5.50% vs. 4.75%-5.00%).
- Limited upside on exit pricing- While there were less competitors bidding on the property when you acquired the property, there will also not be as many investors looking to buy the property when you sale. This will limit your residual sales price in a smaller market.