In recent years, commercial real estate has experienced a major influx in capital. The market is being driven by institutional investors, both at home and abroad. The steep and quick rise of real estate prices has some investors chasing higher yields in secondary markets like Dallas and Denver.
Not only are secondary markets more affordable (and thus, require less upfront capital), but they also offer an opportunity for small-scale investors to buy Class A buildings for a fraction of the cost of Class B properties in primary markets. But is this really a good long-term investment strategy?
In other words: do Class A properties in secondary markets really provide greater risk-adjusted returns than Class B assets located in primary markets?
According to research out of the MIT Center for Real Estate Development: it depends. It depends on what asset class you’re investing in.
To fully understand the study, let’s start with a few definitions.
In real estate, yield arbitrage is when someone buys and sells the same property at different rental yields. For example, a local investor might sell a commercial warehouse he has owned for decades without fully understanding the current market conditions. A more sophisticated investor might realize that the property is listed below market price, so he’ll purchase the warehouse at a discount, only to turn around and re-sell it for significantly more.
There is an entire class of investors that earn a living by capitalizing on yield arbitrage.
Class A vs. Class B Properties
Although there’s no universally-accepted definition of Class A and Class B properties, most in the industry consider Class A buildings to be newer with higher quality finishes, amenities and accessibility. Class A properties tend to be located in the urban core, and oftentimes have their own brand associated with them.
Class B properties, on the other hand, tend to be older in age and function. Finishes tend to be in “fair” or “good” condition, and according to CoStar’s definition, offer “more utilitarian space”. They tend to lack any remarkable amenities, and typically command lower rents than their Class A counterparts. As a result, most Class B landlords tend to skew toward locally-based investors versus those with national or international portfolios.
Defining Primary vs. Secondary Markets
For the purposes of the study, researchers defined “major” or “primary” markets to include New York, Los Angeles, Chicago, San Francisco, Boston and Washington, D.C. “Secondary” markets included Atlanta, Miami, Dallas, Houston, Phoenix, Denver, San Diego, Seattle, Minneapolis and Philadelphia.
Evaluating a Property’s Return
The research team then used historical performance data from the National Council of Real Estate Investment Fiduciaries (NCREIF) to evaluate a property’s typical return. Returns were calculated assuming 100% equity and no debt financing, which allowed for an apples-to-apples comparison regardless of financial structure. NCREIF data was collected and analyzed for the years 2005 through 2013, which captures both peaks and valleys of the most recent real estate cycle. Sharpe ratios were used to assess a risk ratio to each property analyzed.
After analyzing hundreds of properties across asset classes and markets, the research team concluded that both Class B office and multifamily properties in primary markets outperformed Class A office and multifamily properties in secondary markets during the period of 2005 and 2013.
However, a deeper look at the micro-cycles during this time frame is also telling:
· During the “growth period” of 2005 to 2007, Class B properties in primary markets outperformed Class A properties in secondary markets.
· During the “trough period” of 2008 to 2010, Class A properties in secondary markets significantly outperformed Class B properties in primary markets, indicating assets in primary markets are more susceptible to downturns in the economy.
· During the “recovery period” of 2011 to 2013, Class A properties in secondary markets narrowly outperformed Class B assets in primary markets.
These results came as somewhat of a surprise to researchers. The findings indicate that office and multifamily housing in secondary markets are faster to recover than housing in primary markets. This may be because secondary markets require less up-front investment and attract a broader range of investors versus institutional investors that focus on core markets, but who are more cautious when re-entering a market after a downturn.
Interestingly, the only real estate asset class to outperform in the secondary markets for the aggregate study period was industrial.
Class A industrial in secondary markets, like Miami, provided higher returns than Class B industrial space in core markets during the entire study period.
So, what should investors make of these findings?
“The overall empirical results of our study indicate that a savvy real estate investor, who is dedicated to maximizing his long run returns, would prefer to invest in office and multifamily properties in primary markets, and in industrial properties in secondary markets,” explain the authors of the study.
As the old adage goes – location, location, location!
For more information or for a free confidential consultation on leasing or selling your industrial building, contact the Miami Industrial Team at 786-433-2380.