Smaller Markets Can Offer Greater Rates Of Return
Where should smart CRE investors be putting their money these days? SIORs will tell you that you’ll find significant opportunities in tertiary markets.
Conrad Madsen III, SIOR, co-founder and partner in Paladin Partners in Dallas, cites ‘Texas Triangle’ tertiary markets, including Waco, Temple and Hillsboro, and the Port of Mobile/Baldwin County in Alabama—particularly Baldwin County.
What makes each of them a potential “gold mine?” The ‘Texas Triangle’ cities, he notes, are “located in the middle of one of the fastest growing areas in the world, along major interstates, and can service Austin, San Antonio, DFW, and Houston.” He adds that land is more readily available at lower basis.
In Alabama, he says the State Port of Mobile is the fastest growing port and container terminal in North America, with 65 million square feet of demand and 0% vacancy for the last five quarters. Baldwin County, he adds, “is serving two of the six fastest growing MSA’s in the U.S.—Pensacola MSA (No. 2) and Baldwin County (No. 6).”
“I’ve had good success selling investment properties in a tertiary market,” adds Laurie Tylenda, SIOR, licensed real estate broker with CBRE Upstate New York/Capital Markets in Albany, N.Y. “I have several long-terms clients, many of whom are 15+ years.”
For her, the attraction comes down to location. “The Capital district is a tertiary market, but it continues to be discovered, and for several years interest has been increasing,” she asserts. “I think it’s a bit of a trend for investors to look at secondary and tertiary markets because they find a greater rate of return in a smaller market—that’s certainly been the case with Albany.”
Cap rates, she continues, are a little less “aggressive” than they are in primary markets, although it will vary depending on product type and exact location. Tylenda says that as a rule, investors will see greater rates of return. She adds that CBRE recently put out a report that the area is also growing as a tech center. “When you combine that with the educational institutions we have, the state Capitol and the medical facilities, it creates a stabilized and desirable area,” she declares.
And Matt Red, SIOR, who heads the Lake Charles, La.-based firm that bears his name, is high on southwest Louisiana, “because we have the support services for all of these major energy/LNG projects coming into our market, meaning engineering services, supply chain companies, equipment companies, bus transportation, and others in the service business to support LNG development.” All these companies, he asserts, are “expanding their footprints” in the area.
He cites four main reasons for the area’s growth:
- An abundance of natural gas in the U.S. (pipelines carry the gas from Pennsylvania, the Dakotas, and Texas).
- Pipeline infrastructure to the Henry Hub (a distribution hub on the natural gas pipeline system in Erath, La.) and the deep-water port/export facilities required to ship the compressed natural gas abroad.
- A huge energy-dependent market outside of the U.S. that buys the LNG; and
- The current administration is the friendliest in decades to energy development and has the stated goal of energy independence for America.
If businesses are relocating or expanding into a particular market, positive commercial real estate effects should follow across most asset classes.
“I can make the case that all the major CRE product types are ripe for investment since we’ve experienced a reset in valuations over the recent past; we are almost certainly at the proverbial ‘bottom’ of the current cycle,” asserts Landon Williams, SIOR, executive vice president, Investment Sales for Cushman & Wakefield in Memphis, Tenn. “The first part of the universal investment model of ‘buy low, sell high’ is applicable now in commercial real estate.”
From a geographic perspective, he continues, mark>ets with population and industry growth will continue to see capital flow in their direction. “The growth in primary markets in Florida, Texas, and others have been well documented, but we are also seeing investors give more attention to smaller markets like Memphis, Knoxville, and Huntsville, where initial basis is lower as future prospects look bright,” he observes, noting that the boom in growth in larger Sunbelt markets is a “rising tide” that will “lift all boats.”
Nothing is Guaranteed
Of course, you won’t hear many SIORs talk about “sure things” when it comes to CRE; there are always risks in any venture. What are some of the potential barriers for this current crop of “gold mines”? “We’ve been in a season of uncertainty,” says Williams. “The wind could shift for multiple global issues which could negatively impact real estate investments and our economy.” If that should happen, he adds, larger markets may be able to absorb those impacts better than smaller markets.
And speaking of winds, Redd cites natural disasters and severe weather as the greatest threats. “We had a heck of a hurricane roll through here in August of 2021 and it was very destructive,” he recalls. “It’s taken us a few years to rebuild and fortunately, for the most part, we have. We are not odds makers here—we’re in real estate—yet typically these are once-in-a-lifetime events, so we’re moving forward.”
Moving Forward, Indeed
Redd says the area is now in Phase II of what he calls the “LNG Boom.” His company, for example, is working with a transportation firm on several projects to develop and enhance its warehousing, storage and maintenance facilities infrastructure in the Lake Charles area, “as my client anticipates huge demand for transportation services to get workers to and from job sites as they commute in from other parts of southeast Louisiana.”
“There are risks in any market,” adds Tylenda. “Investors need to do their homework accordingly, but our market tends to be slow and steady—we don’t tend to have huge increases in good times, but in return we tend not to have great downturns in bad times.”
Determining Market Potential
What factors do SIORs use to determine whether an area is ripe for investment in the first place?
“Incoming phone calls is the shortest answer, and they are mostly about acquisition inquiries and related financial investments in the community, including site selection,” says Redd. “When we have a number of FID announcements–final investment decisions–that means it’s a ‘go’ for these energy companies.
They’ve done all their due diligence; monies were approved by investment companies and all the government agency consultants have preliminary or permanent development agreements in place to do the projects.” For example, he shares, a $17 billion LNG facility was recently announced by Woodside Energy, and Australian-based energy conglomerate–DBA as Louisiana LNG Co. “From a real estate transaction perspective, the service companies I mentioned are willing and prefer to do long-term 10-year leases,” he adds.
“I rely on key metrics such as population growth, industry growth, and supply constraints of a particular market to identify the next opportunity for investment,” says Williams. “If businesses are relocating or expanding into a particular market, positive commercial real estate effects should follow across most asset classes. More jobs result in the demand for more housing, more retail, more office, etc.”
Madsen cites the following four factors in his decision-making process:
- Low vacancy rates
- Demand out-pacing supply 4 to 5 times
- High barriers to entries
- Solid drivers
“I look at other markets as a whole just to see what types of activity and investor sentiment they have,” notes Tylenda. “And that gives me a larger look at cap rates.”
It takes more effort to identify the promising markets not yet on the radar. It can feel like the investor is blazing a new trail, but the reward must be worth the risk.
Convincing the Skeptics
Tertiary markets are not for every investor. What strategies do SIORs use to convince some of the skeptics that an area they believe in is ripe for investing?
“The more data we can track, the more educated decision an investor can make,” says Williams. “The key is also on how to interpret the data; it helps to see a metric at any given point in time, but it is even more beneficial to see a metric trending over time. It is the difference between a photograph and a movie — the movie gives more context.”
Redd says he shares “the multiple commitments by big energy companies in the billions of dollars and real estate occupiers that are committed to 10-year leases.”
“I talk to them about the larger employers that are here, the steady population, the growth in several of the energy-related companies, and the investment the region is making in itself,” says Tylenda.
Madsen cites Laredo as a prime example of a market “selling itself.” “Most investors are scared to take the risk until they see others hit a few successes, then they flood the market at the end of a cycle,” he shares.
“It is not quite as challenging to make investment decisions in the established markets; those roads have been paved, so the path is clearer,” Williams explains. “It takes more effort to identify the promising markets not yet on the radar. It can feel like the investor is blazing a new trail, but the reward must be worth the risk.”
For Redd, it might just come down to rooting for the “home team.” “I live here, so it’s not as if I go looking for markets—the market is here,” he declares. “Storms and politics can work as temporary setbacks, but global demand for energy isn’t going away anytime soon.”
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