Should You Be Investing in “Secondary Markets”?

Should You Be Investing in “Secondary Markets”?

New York, NY – Since 2008 the global gateway real estate markets have been the “flight to quality” investment strategy of many investors. Because of this increased demand, stable fundamentals relative to other markets, and “pretend and extend” loan workouts, most core markets did not see steep declines in commercial real estate values as was expected after 2008. As the U.S. economy started to bottom out these core markets saw a dramatic increase in activity and prices increased due to cap rate compression. Now, with cap rates at historically low levels and interest rates finally creeping upward, it is time to reconsider this strategy.

Consider a current gateway city investment versus a secondary and tertiary market investment.

For the gateway market example the following assumptions have been made: The asset purchased is a $5 million N.Y.C. multifamily walk-up property; the average going-in cap rate for this property type and market is 4%; the asset is purchased based on in-place net operating income (NOI); and not on projected NOI (which many investors are being forced to do by lack of supply.)

So if the cap rate for this property stays at 4% and NOI grows then the property will appreciate in value. However, let’s look at what might happen if we see rising interest rates that force cap rates to expand and not contract, as they have over the last three years or so.

A 200bps expansion in cap rates, from 4% to 6% will represent a 33.33% loss in value. However the plan is to grow NOI, not keep it the same, as assumed above. So how much does NOI need to grow simply to keep the value of this property the same with the assumed expanding cap rate? To keep the same $5 million value of the building one would need NOI growth of 50% over the period of time that this cap rate expansion occurs.

Mascia Dev-NYREJ-GlobalGateway

For the secondary/tertiary market example the following assumptions have been made: The asset purchased is $5 million Columbus, OH multifamily property; the market average going-in cap rate for this type of building is 8%; the asset is bought based on the current in-place NOI; and the business plan is to raise NOI through renovating the property and raising rents to catch up with market increases.

In the past 12 months we have seen increasing competition in these secondary and tertiary markets and expect this to increase as others come to the same conclusions.

Part two continued from the September 24th, 2013 New York City Financial Digest edition of the New York Real Estate Journal.

If a cap rate expansion of 200 bps takes around five years (rather slowly) then 10% per year NOI growth is needed in the gateway market and 5% per year in the secondary and tertiary market to keep values the same. While the growth needed in both markets is aggressive simply to keep the underlying asset value the same, the secondary and tertiary is clearly much less drastic.

At Mascia Development, we have focused on secondary and tertiary markets for the last three years as a defensive strategy to protect our downside risk in an expanding cap rate environment and also to take advantage of the much higher current returns offered there. We saw significant price declines in most secondary and tertiary markets and did not see the same cap rate compression as in core markets. With long-term low interest fixed rate debt and improving fundamentals we see significantly more upside in secondary and tertiary markets with a much greater downside risk protection.

In the past 12 months we have seen increasing competition in these secondary and tertiary markets and expect this to increase as others come to the same conclusions.

Mark Mascia, LEED-AP is president & CEO of Mascia Development, LLC, New York, N.Y.

Written by Mark Mascia

Mark Mascia

Mark has the overall responsibility for managing the investment and operating activities of Mascia Development.

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