Pricing in the main market is pushing investors beyond the gateway cities. Stephanie Schwartz-Driver reports

As the pricing and compressed yields push investors beyond the US gateway markets, the definition of secondary is changing and the US economy strengthens.

Investors interested in committing to the US are finding deals harder and harder to come by in sought-after gateway markets such as New York City, Los Angeles, and Washington DC. And they’re feeling the push of the crowd even in markets like Boston and Seattle, which were once outside the mainstream.

“To us, it seems like a natural progression in the cycle,” says Tim Wang, head of the investment research group at Clarion Partners. “As yields go down to the point that investors seek higher returns, it is a natural move for investment to flow down.”

Investors move beyond the gateway cities sector by sector, says Spencer Levy, executive managing director at CBRE Capital Markets. “Multifamily is first, because of the predictable yield profiles of the investments. Then investors start looking at the best of other classes, led by industrial, because industrial properties do not follow the typical definition of primary and secondary since they are logistics-driven.”

Today, Clarion analysts define primary market cities as Boston, Houston, Los Angeles, New York, Seattle, the Bay Area, and Washington DC. These 24-hour cities have a high concentration of high-grossing and high value-add industry, have an affluent and educated workforce, are relatively supply-constrained and are liquid.

Classic secondary cities, according to Wang, show very strong job and population growth, and offer a high quality of life and affordable living, but they are also less supply-constrained. He cites Austin, Salt Lake City, Denver, Miami, Portland, Raleigh, San Diego, and Orange County, near Los Angeles, as examples.

What is interesting is that “the definition of primary and secondary is constantly evolving,” says Levy. “Seattle today is considered a gateway city, and Denver is changing status. Other markets to watch include Portland, Raleigh, Austin, and even San Antonio.”

Levy points to key factors that endow cities with upward mobility. One is their economic base. Today, drivers of the US economy include healthcare, education, energy and technology. Lifestyle also attracts new employees, especially those starting out in their careers. The work-life balance in cities like Portland or Denver is attractive to younger workers, Levy says.

Austin, Texas, is another city that is attractive to younger workers, says Wang. It is also the home of the state government and University of Texas and is evolving into a technology hub.

Another city to watch is Miami. “We consider Miami a secondary market, because it is not large enough or deep enough yet,” says Wang. But he points that it is essentially the gateway to Latin America, and there is a strong inflow of foreign capital. All real estate sectors there, not just condos, are beating their benchmarks because of the city’s strategic location.

The Bay Area, San Francisco and the nearby Silicon Valley region, is another example as the definition of gateways broadens out beyond the traditional central business district (CBD).

“The areas of San Jose and Silicon Valley are global drivers of the economy now,” says Sommer Johnson, investment manager at Grosvenor Americas. “They have some areas of the highest rents in the world. Although they are not quite as hot as San Francisco has been, there is only a quarter or two lag in rents and vacancy rates.”

Grosvenor recently made a major acquisition in San Jose, Century Plaza II: a 99,000 sqft class-A office building within walking distance of Santana Row, Silicon Valley’s top retail destination. Its walkable amenities as well as good transport links was a major draw, Johnson says, especially in San Jose, which is largely a drive-in, drive-out city.

Grosvenor focuses on the Bay Area, Los Angeles and Orange County, Seattle, and Washington DC. It defines gateway or primary markets as the cities and their surroundings, based on economic growth potential. For example, while San Jose is gateway, Oakland (a San Francisco contiguous suburb) is not. “We call San Jose and Silicon Valley a gateway area but not a downtown,” Johnson says. “We stick to the broader gateway markets but we look beyond the urban downtown.”

Grosvenor’s criteria include urbanised locations, proximity to transport, solid dynamics and locations where people want to live.

It can be tempting to move beyond the gateway markets, says Johnson. “We hear about properties for sale in secondary markets that get a handful of offers, while in gateway cities they may get 20. Bidders are getting frustrated. You have to be careful not to have discipline creep. We are not looking at a property just because it has fewer bids.”

Wang adds: “You have to be mindful of the difference between primary and secondary markets. You have to really think about supply, liquidity, and your holding period.”

And, says Wang, “there is always a risk in secondary cities”. He adds: “One key criterion is your investment horizon. In secondary cities, it is three to five years, rather than 10 years. You can hold office in Washington DC through cycles and it will come out on top. With secondary markets, you have to time your entry and exit.”  

These markets are more volatile in their fundamentals and asset pricing. For example, local governments may offer incentives to attract companies to locate there, but when they end, the businesses may move on.

But Levy takes a different approach. “The challenge in secondary markets is not having a long enough investment horizon,” he says. “The biggest risk in secondary markets is liquidity risk; they are the first markets that tighten up when things go soft. Investors need to be able to manage through periods of tight liquidity.”

Despite the higher risk, foreign investors “are advised to look outside the gateway cities to achieve better cash-on-cash yields,” Levy says.