Commercial real estate investors like to think about geographic markets in terms of the overall population, population density, and growth. In commercial real estate (CRE) circles it is common to separate markets into primary, secondary, or tertiary groups to distinguish the characteristics and demographics in a way that is easy to understand and communicate to investors.
In this article we will focus on tertiary markets. Specifically, we will explain what a tertiary market is, why commercial real estate investors might consider investing in them, and potential downsides of tertiary markets. By the end of this article commercial real estate investors will have the information necessary to decide if investing in a tertiary market is right for them.
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Tertiary Market Definition
In the commercial real estate industry, investors group markets by size. Tertiary markets are smaller metro areas that lack the population density and public infrastructure found in primary or secondary markets. Investments in these markets are subject to the ups and downs of the local economy, but investors who know these markets well have the potential to generate strong returns.
The idea behind tagging a market as primary, secondary, or tertiary is somewhat similar to how investors apply a rating to a property to quickly identify the risk/return profile (class A, class B, etc.). There is no hard and fast definition for what a tertiary market is. That said, we can put some general rules around what is generally considered a tertiary market.
- Lower cost of living: Compared to primary and secondary markets, tertiary markets tend to have lower housing prices, oftentimes lower local taxes, and certain goods and services may be purchased for less. In some cases a tertiary market with a lower cost of living can attract new residents and generate the economic growth to eventually end up as a secondary market.
- Slow but steady growth: Most tertiary markets can be characterized as having job growth and population growth that is pretty comparable to the national average. Since they usually can’t attract employees like major cities can, tertiary markets usually grow organically on the backs of local businesses.
- Less public infrastructure and amenities: Most metro areas have public infrastructure that benefits millions of residents and visitors every year. Things like public transportation, public art galleries, and recreational spaces attract residents and help to keep property values strong and rent growth robust. Tertiary markets usually have some element of this but not to the extent of a major city.
- Population is usually, but not always, below 1 million residents: Primary markets like New York or Los Angeles are among the most populous cities in the world. Tertiary markets, on the other hand, are generally small cities catering to its residents and the small towns nearby.
What Investors Should Consider Regarding Tertiary Markets
Investors in any market should take the time and put in the effort to do due diligence on any deal that they consider. Being able to complete due diligence in a tertiary market requires knowledge of the local real estate market and market fundamentals, including things like cap rates and occupancy rates.
For real estate investors considering investing in a tertiary market, it is important to understand the dynamics driving the local economy. For example, a tertiary market like Omaha, Nebraska, is a relatively small city but has a pretty strong roster of corporations headquartered there. This might bode well for the job market and certain commercial property asset classes such as office buildings.
Another important thing to consider when looking to invest in a tertiary market is how to build a network of brokers, lenders, and property managers to ensure success. Many commercial real estate lenders are regional, so just because an investor has worked with them on other deals elsewhere, does not mean that the lender will be able to extend financing in the tertiary market of interest.
Why Investors May Consider Tertiary Markets
Plenty of investors, even those based in primary, or gateway markets, center their investment strategy on tertiary markets. And for good reason, as we will see next.
Tertiary markets usually don’t attract institutional money the way gateway or secondary markets do. Investors who specialize in tertiary markets and put in the time and effort to know that market well, might be one of only a few who are in that position. These investors can sometimes generate higher returns than they might if they chose to invest in a primary market where large private equity firms and real estate investment trusts (REITs) deploy millions or even billions of dollars.
Investing in any commercial real estate market is a very capital intensive investment strategy. That said, tertiary markets tend to offer more bang for the buck. Investment property in these markets usually trades hands at a lower sale price per square foot compared to a primary market, and valuation metrics are often softer.
One of the key things for real estate investors to think about when underwriting a deal is the cash flow they will receive in relation to the price paid for the asset. Tertiary markets can offer more value in this sense, and many investors choose to focus on these areas with this idea in mind.
When many real estate markets face a downturn, like they did during the COVID-19 pandemic, tertiary markets tend to be more insulated. Sometimes these smaller markets are dominated by a particular property type or employer. For example Amazon has established large distribution hubs in a number of tertiary markets across the country, and having a stable source of jobs can keep these markets strong when others are facing headwinds.
One of the problems with primary markets is that there is a great deal of institutional capital invested in properties there. Whether an institution is focused on multifamily, value-add or single-family investments, it is likely a downturn will cause the institution to pause or pull some capital out of the market. This can worsen the situation. Tertiary markets, as we discussed earlier, typically don’t attract the same level of institutional capital, and therefore, tend to see smaller swings during hard times.
Downsides of Investing in Tertiary Markets
We’ve discussed some of the benefits of investing in tertiary markets, but investors need to be aware of the downsides and risks that exist in these markets before jumping in.
Smaller markets tend to have fewer investors compared to larger cities, and this generally means there is less liquidity in tertiary markets. Investors who need to sell a commercial property may have to be patient and wait for the right buyer to come along. In a worst case, the property owner might have to cut the asking price or offer other concessions to attract a buyer. Major metro areas, on the other hand, tend to have plenty of investors looking to buy and sell, so unloading property there can usually be done quicker.
For these reasons, first-time investors would do well to avoid tertiary markets unless they are intimately familiar with the area.
Similarly, long-distance investors who want to take on renovations in these markets should be warned that it can be difficult to find reliable labor and managing the project in a distant tertiary market can be difficult.
Examples of Tertiary Markets
Tertiary markets can be found all over the United States. We’ll discuss two here as examples.
Memphis is a city of about 650,000 residents in western Tennessee.
Cost of living: According to Zillow, the median home price in Memphis is $157k, which is below the national median of $357k. Clearly, Memphis has a cost of living lower than many parts of the country.
Growth: According to the Bureau of Labor Statistics, the number of employed workers in Memphis has grown from about 575,000 in 2012 to 620,000 in 2022. This represents 7.8% growth in the total number of employed workers over the ten year period. This rate of growth fits the mold of a tertiary market because it has generally been stable but not fast growing, like Austin, TX or Seattle, WA.
Infrastructure: Memphis is home to an international airport and has major interstate highways passing through it. However, it lacks the public transportation infrastructure common in secondary markets. For instance, Memphis does not have a network of public rail transportation.
Omaha is a city of about 480,000 residents in eastern Nebraska.
Cost of living: According to Zillow, the median home price in Omaha is $270k. Similar to Memphis, Omaha has a cost of living lower than many parts of the country.
Growth: According to the Bureau of Labor Statistics, the number of employed workers in Omaha has grown from about 445,000 in 2012 to 500,000 in 2022. This represents 12.4% growth in the total number of employed workers over the ten year period. This rate of growth is higher than what we saw for Memphis, but it pales in comparison to Austin, TX (44% employment growth between 2012 and 2022).
Infrastructure: Omaha is similar to Memphis in that it is home to an international airport and has major interstate highways passing through it, but it does not have public transportation infrastructure on par with major cities (passenger rail, subways, trolleys, etc.).
Private Equity Real Estate Investing in Tertiary Markets
Individual investors looking to put money to work in tertiary markets can certainly do well for themselves, but investing in these markets can be difficult and very time consuming. Many investors who are interested in making investments in these markets choose to invest with a private equity sponsor that specializes in the market and asset class.
Working with a private equity sponsor can spare real estate investors the time and effort needed to learn the ins and outs of a tertiary market, including things like zoning laws. Investing with a private equity sponsor can also help individual investors to achieve the right level of diversification.
Individual investors who buy a deal in a tertiary market then have to manage the property themselves, which is very time consuming, or they have to hire a property management firm to do the work for them. Finding a reputable property management company in a smaller city can sometimes be challenging. An experienced private equity sponsor will either have strong connections to property managers, or they will manage their own properties like we do.
Summary of Tertiary Markets in Commercial Real Estate
There is no hard and fast definition for what a tertiary market is, but there are some general rules real estate investors tend to use to define a tertiary market. These include a lower cost of living, slow but steady growth, less public infrastructure and amenities compared to metro areas, and populations that are usually below 1 million residents.
Many investors like tertiary markets because they offer less competition, better value on acquisitions, and less volatility than markets where instructional investors focus. At the same time, there are downsides to investing in tertiary markets, including less liquidity and fewer property management firms and contractors for when maintenance work needs to be done.
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