While many CRE equity investors continue to seek “Safe Harbors” for their investment capital, some equity investors are now focusing on deploying their capital into secondary commercial real estate markets in an effort to achieve their target investment returns. While we are not expecting 500K SF Speculative Offices to start popping up in Waco, many secondary markets offer attractive risk-adjusted returns for commercial real estate acquisitions. By comparison, Cap Rates are higher in secondary markets, and there is less competition for deals.
In Texas we are blessed to have a diverse economy, a pro-business climate, and healthy lending institutions that have made the recovery less painful than in other states. Those positive attributes have led many CRE sponsors to look outside of the larger cities in order to find opportunity and value buys. While most equity investors still prefer a Dallas or a Houston investment, many will look at secondary and tertiary markets for the right deals.
So, what is the right deal? As in any market, the location is still paramount, especially for Multifamily, Retail, or Office properties. For existing products, newer built properties are going to get a harder look than the older products, but even that will change as investors chase yield. Looking at the “price per pound” will always be important, but don’t be surprised to see investors stretch a little more if they think the going-in Cap Rate makes a lot of sense.
Even if the price per s.f. seems aggressive, the value-add play can still be feasible in smaller markets. However, the business plan may be more appropriately “dialed down” in terms of proposed renovations or tenant improvements when the drivers to differentiate the renovated project are not as competitive.
Perhaps the most important consideration is to pursue projects that you would like to own (versus a quick flip), even if it turns out to be a long-term investment. Most equity is not looking for long-term holds, but, rather, equity providers prefer a three- to five-year investment time horizon.
However, with economic uncertainty still on the horizon, a fallback position on an investment should always be, “If things don’t go perfectly, we can always own the property for the long-term and enjoy the cash flow.” Putting yourself in a position to be able to address both the upside and/or downside of a particular investment will come in handy when soliciting equity investors to consider an acquisition in a secondary market.
No doubt about it, getting lenders and equity providers to go to secondary markets is always a challenge. But, for the right deal, at the right price, with the right sponsor, finding the capital is not impossible nor an automatic “No” just because the property is located in a secondary market.
By Hook Harmeling
Metropolitan Capital Advisors