Institutional Real Estate Americas: Research in Secondary & Tertiary Markets | Durable Value Ep. 91
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Transcript: Ryan Swehla: On this episode of Durable Value Podcast, we're going to play a recent interview that I had with Institutional Real Estate Americas regarding secondary and tertiary markets and the recent research that we've completed on that. Hope you find this beneficial
Hi, this is Ryan Swehla, co-CEO with Graceada Partners, and we focus on apartments and multi-tenant industrial in the Western US, but we focus on smaller markets in the Western US.
So first, let's talk a little bit about definitions. We generally view secondary and tertiary markets in kind of two buckets. Tertiary markets defini-definitionally, we focus on half a million to one and a half million people, the MSA population. Secondary markets, we generally describe as two million to four million people roughly.
Um, and so when we're talking about secondary and tertiary markets, I think it's important to understand that we're not talking about ten thousand population towns, uh, but rather, you know, large cities. What's interesting about these markets is they tend to be dominated by private capital, non-institutional capital.
So, uh, they're less efficient. Private capital tends not to operate as efficiently as institutional capital, and it's very analogous to lower middle market private equity, where it's smaller deal sizes. It tends to be mom-and-pop owners or private capital owners who have different investment objectives than the institutional operator.
And so it creates kind of a, a better investing environment. We recently completed some research on comparing secondary tertiary markets in the Western US to primary markets in the Western US, and there were some interesting findings. First of all, um, w-with the research, we looked over the last twenty years, so that was inclusive of the GFC, inclusive of COVID.
And what we found through that research is that the secondary and tertiary markets in the West actually perform better economically than the primary markets. Um, in all the economic measures, GDP growth, population growth, job growth, unemployment, generally, secondary and tertiary markets performed better than primary markets.
Now, that research was only done on the Western US, so I would certainly caveat that the analogy may not be true in other parts of the United States, but the Western US generally is kind of the expansionary part of the United States, and these markets tend to have higher affordability than West Coast primary markets.
So it's not surprising that over time, uh, over decade, over decade, these markets have seen long-term population growth and, and in-migration.
Interestingly, we've done some research looking also at not only how the economic performance primary market versus secondary, tertiary, but we've also looked at the real estate performance, so looking at things like sale price, occupancy, um, the vacancy rates, um, cap rates, and how those move over time.
And we looked over the last 20 years, so again, inclusive of the GFC and the pandemic and the rate hike environment that we just experienced. Broadly speaking, secondary and tertiary markets perform about the same as primary markets. So even during the, the downturns, uh, there, there's kind of a conception in institutional realm that secondary and tertiary markets didn't perform as well as primary markets during the GFC, and the data shows that, you know, when you look at the real estate values, the value decline during the GFC was about the same between secondary, tertiary markets versus primary markets.
When you look at things like occupancy, uh, the occupancy decline or the vacancy increase during the GFC was about the same between the two. So broadly speaking, real estate performs about the same, whether you're talking about smaller markets or larger markets. One interesting thing that we found, uh, during this research that was a little bit surprising is the one area where the two differentiated was in net absorption.
So net absorption, as you know, is, uh, looking at supply and demand balance. You know, if high, uh, net absorb- high positive net absorption means a lot of new supply is being taken, and obviously negative net absorption means that, uh, there's more new supply than there is, uh, demand for that new supply.
Interestingly, primary markets have higher volatility in net absorption than secondary and tertiary markets. So that means that the supply-demand equilibrium is actually more volatile. It swings more in primary markets than in secondary and tertiary markets. And one would naturally think the opposite.
Hey, primary markets, these are more robust markets. They have better s- demand drivers, and therefore they have better kind of supply-demand eli- equilibrium. And meanwhile, secondary, tertiary markets have lots of available land. Uh, it, it's easy to build, and so it'd be easier to have greater volatility in supply and demand.
The data shows the opposite, and what we concluded through that is that the presence of institutional capital or the presence of capital is a greater, uh, driver of volatility in supply and demand than the presence of cheap and abundant land. Um, when you look at, uh, say, the San, the San Francisco Bay Area or Los Angeles over the last twenty years, there's been greater, uh, supply and demand, uh, volatility than in places like Bakersfield or Fort Collins, Colorado.
And again, I think that is counter to what we would all naturally think, but, uh, the data shows that, um, clearly the, the volatility is higher in the primary markets. I think that's, that's the biggest difference.
Over the last year, it's been really interesting to see how these markets have performed differently. Um, as I mentioned earlier, secondary and tertiary markets tend to have more private capital, uh, than institutional capital, and I think that that ultimately leads to different performance. Uh, one area where I would say these markets have performed differently is transaction volume Uh, we've all seen transaction volume drop off a cliff over the last few years, and we're starting to see it return back, or at least we're starting to see that it's h- trending toward returning toward a regular transaction volume.
We started to see in our markets a turn toward regular transaction volume actually in Q3 and Q4 of last year. And then by Q1 of this year, we are already back to kind of a normal transaction environment, or at least our, our pipeline is, uh, kind of back to a normal transaction environment. And I think that has to do really with that presence of, of private capital versus institutional.
Institutional tends to be a little bit more herd. You know, we're all in or we're all out, and that's because they all have the same motivations. We all have the same motivations, and so we're operating much more in lockstep. Private capital, on the other hand, has kind of external motivations for transacting.
Uh, you know, it's estate planning or the patriarch passed away, or they have a 1031 exchange. And so there are th- these reasons why they're transacting when institutional capital is not. So it has been interesting to see that the, the return to kind of a little bit more normal market has already, uh, occurred in these markets.
Another interesting dynamic is that, uh, we often get asked, as I'm sure most managers do, uh, uh, what about this wall of maturity and the distress, and are we gonna see lots of distress coming into the market? And here again, I would say these markets perform a little bit differently. We have not seen the level of distress opportunities.
And again, I would say that's attributable to the fact that it's m- mostly private capital. Private capital, for the most part, tends to be lower leverage. Um, sometimes they own properties free and clear with no debt, and so you just don't have the level of distress that you do in markets where there's, uh, groups that are using more financial leverage.
Um, and then the last thing I'd add to that is, um, over the last couple of years, we've started to see y- nationwide, um, on apartments and industrial, which are the two asset types we invest in, we've started to see some negative rent growth, um, where we've had more supply come on the market and it's, uh, turned rent growth to negative.
In the markets that we operate in the Western US, again, predominantly private capital, predominantly not institutional capital, we haven't seen as much of that oversupply. And because we haven't seen as, as much of that oversupply, we actually haven't seen rents decline. Um, so most of the markets that we operate in, both in industrial and in, um, apartments we've, uh, predominantly seen it stay positive and not go to negative.
Couple exceptions to that are the Salt Lake area and then the Denver area, and those are two markets that, not surprisingly, saw more presence of institutional capital, which meant more new building, which meant more oversupply. So again, uh, institutional capital drives, uh, you know, oversupply
This is a great question. Um, there's, there's kind of a, a misconception about liquidity in smaller markets. Um, the, the data shows, and, and we've done some research recently on this, that these markets actually have a high level of liquidity, but that liquidity is in the right asset size, which is a smaller asset size.
It's not in kind of these big institutional asset sizes. And that's not surprising because when you're working in that smaller asset size, we, we buy generally between 10 to $40 million asset sizes. When you buy in that smaller asset size, you have both institutional capital coming down and transacting in that size, and you have private capital coming up and transacting in that size.
So you, you have that nice mix where you have both institutional and private capital. Um, we... In, in the research that we did, we also highlighted a couple of sales we did during 2023, which was probably the hardest year to sell assets, '23 and '24, and we sold two assets at very strong returns and, and both of those assets had 50 to 80 groups in the data room.
We had six to 10 offers, four to six best and finals, and a, and kind of an equal mix between institutional and private capital, and it really just demonstrates that even during a downturn in transaction volume, there's still a high level of liquidity in these markets. And a- again, I, I mentioned this earlier, but that partly goes back to when you look at the data, the smaller transaction size stays much more liquid during downturns than the larger transaction size, and that's because private capital has motivations that are external to the market.
They have motivations for buying and selling that are, y- you know, that are more motivated by their circumstance than it is by the market timing. And so, uh, I, I like to, uh, remind people that if liquidity is... or, or risk of liquidity is, is a big concern, then really, um, in- institutional investors should be buying smaller asset sizes, not larger asset sizes, 'cause that's where the illiquidity really exists.
So over the next 24 to 36 months, really we've started to already see that the values have bottomed out. Uh, as I mentioned earlier, uh, transaction volume, a- at least for us, has started to return back to kind of a normal transaction volume, which tells us that we've kind of reached the bottoming in values.
So I think we'll continue to see market strength. Um, the markets that we operate in, in secondary, tertiary markets in the West, have had year-over-year positive population growth, uh, for decades and decades, so we think that trend will continue. Um, and so with that, we see the next few, few years really being kind of a tailwind environment or returning to a tailwind environment.
Uh, obviously we're starting with a reset in values, so, um, hopefully we won't get to the frothiness for a few years at least. Uh, but it definitely feels like the markets have kind of restarted and, uh, it definitely feels like a good opportunity over the next, uh, two to three years in these markets.
Ryan joins Institutional Real Estate Americas to share Graceada Partners' latest research on secondary and tertiary markets in the Western U.S. and the results may surprise you. From outperforming primary markets economically, to lower supply volatility and stronger liquidity than conventional wisdom suggests, Ryan breaks down why smaller markets deserve a closer look from institutional investors.
Timestamps:
0:00 - Intro
0:50 – Defining secondary & tertiary markets
1:58 – 20-year research: economic outperformance vs. primary markets
3:32 – Real estate performance comparison: values, occupancy & net absorption
7:17 – Transaction volume recovery & the role of private capital
10:38 – Liquidity in smaller markets: debunking the misconception
13:55 - Conclusion