When there is so much focus put on primary and gateway markets, what's the draw of secondary and tertiary markets?
Defining Markets
Before we can answer that question, let’s talk about what makes a secondary or tertiary market. Real estate experts define markets in many ways, which causes infinite confusion for real estate investors. Opinions on market classification vary depending on who is asked and the criteria by which they measure, because there is no concise definition or standard practice across the industry. One expert offers this definition:
"A primary market has 5 million or more people. A secondary market has 2 million to 5 million people. And a tertiary market is under 2 million people."
Narrow views like these are very common. Under this assumption, Austin — one of the most robust real estate markets in the nation — is considered a tertiary market. But I consider Austin a gateway market, similar to Seattle.
Instead of focusing on a single indicator, we create a matrix of information, including population, job growth, traditional and alternative economic drivers, and cap rate analysis. Tertiary markets can truly be defined by synthesizing a wealth of information. More specifically, I believe a tertiary market has steady but controlled job growth, population under one million people and a combination of traditional and alternative economic drivers. Cap rate compression is also a sign of growing competition and market viability. In contrast, gateway markets act more like primary markets by the numbers, specifically in their cap rate compression and spread.
Others factors worth considering when classifying markets include traditional economic drivers like investment activity, sales volume, strength of the economy, availability of debt, growth rates, occupancy, rent growth, cap rates and market stability. A good example of a nontraditional indicator would be whether or not markets have direct flights or major league sports teams.
As market fundamentals, investment strategies and investor sophistication transform, it becomes more difficult to label specific markets. Fund managers and developers will end up with different market definitions based on their own investment criteria. This is a significant and important process that benefits investors. A static or overly simplified market classification will hold back any successful investor.
Investing In Secondary And Tertiary Markets
Private and institutional investors are branching out into smaller markets to meet investment measures and achieve higher returns. According to an article published by National Real Estate Investor (paywall) in January of this year, “More than half (55%) of the apartment properties bought and sold for more than $1 million in 2017 were located in secondary and tertiary markets … up from 42% in 2010.” What is driving growth in these marketplaces?
There are a few key benefits: They are less volatile in downturns, which makes them particularly attractive late in the investment cycle. Deals in these markets are not overvalued and offer higher returns. They also offer stronger growth potential due to a lower cost of living and less supply.
Key Steps For Investing In Secondary/Tertiary Markets
How can you be successful when investing in secondary and tertiary markets?
1. Analyze individual characteristics present in the market, and compare them to national trends.
2. Look closely at job growth not just at the macro level, but also on the micro level to confirm your own investment assumptions.
3. Don't consider traditional economic drivers alone. Imagine analyzing the Denver market without considering the huge boom in their culinary and cannabis industries. You would end up with a narrow and confused view of the local economy.
4. Cap rate compression has indicated a competitive environment, so look at 10-year spreads.
Bottom Line
Pinning down market definitions can be confusing, but looking at hard data in smaller markets and comparing it to qualitative economic drivers will show higher yields and greater spreads for secondary and tertiary market real estate investments.
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