Economist’s View: The Engines That Could

Why secondary and tertiary markets are picking up steam.

Ratiu_George_800x600We find ourselves in the seventh year of the post-Great Recession rebound, yet there is a widespread sense that we are still waiting to “feel” the recovery. Multiple factors contribute to that sensation. Economic growth, as measured by gross domestic product, has been modest at best. The first and second quarters were downright sluggish, mustering annualized growth rates of only 0.8 and 1.1 percent, respectively.

Since taking drastic steps to stabilize the financial system in 2008, the Federal Reserve has pushed the envelope with its monetary policy in a bid to reinvigorate an ailing economy. Years of rock-bottom interest rates and the unprecedented monetary easing have certainly buttressed and stabilized the financial system in general, and banks in particular. Despite these efforts, economic growth has not reached the hoped-for accelerated pace.

Yet signs of economic renewal have been visible. Along with the financial recovery, employment rebounded, filling the gap of nearly nine million jobs lost in the recession. That, in turn, boosted consumer optimism and revived the residential housing market.

And just as the proverbial rising tide lifts all economic boats, the run-up in real estate and financial markets has certainly lifted the net wealth of consumers. Coastal gateway cities were the early beneficiaries. However, inland metros and some smaller markets have also been riding the upward trends of recovery.

For commercial real estate in major markets, 2010 marked an inflection point. Investors returned to the markets and have been driving sales volume toward its pre-recession peak. Prices for commercial assets hit new heights last year, but investors stepped back during the first half of 2016, pondering whether the rapid price appreciation signaled that a correction was in order. Some investors are beginning to wonder whether the markets are showing early signs of a cyclical downturn.

Late Bloomers

Amid the concern about large-capitalization markets, it is telling that a number of other metros did not begin to come back until 2013. These, of course, are the secondary and tertiary markets. Many of them lagged their larger counterparts in both entering and exiting the recession. They have, however, been steadily growing over the past four years. This year, these markets are driving growth in commercial real estate markets. Let’s call them “the engines that could.”

Demand for commercial space was robust in the first half of 2016, marked by declining vacancies and rising rents. In large-cap markets, developers took note of those improving fundamentals and have been filling the construction pipeline, particularly for industrial and multifamily properties. While office and retail construction is more modest, the project pipeline is nearing its pre-recession peak.

According to a report by Boxwood Means, the office construction pipeline is within 14 percent of its 2007 peak volume. The industrial and retail pipelines are about 19 and 33 percent from their 2007 high marks, respectively. In contrast, the pipeline for all asset categories in small-cap markets remains almost 79 percent below its 2006 peak.

While that small-cap supply pipeline remains subdued, demand has been swelling. As noted in the National Association of Realtors’ Commercial Real Estate Outlook, leasing activity across the board accelerated from a 1.3 percent increase in the first quarter of 2016 to 8.7 percent during the second quarter. As demand outpaced supply, vacancy in small-cap markets declined and began to converge with rates in large-cap markets.

Taking Notice

The sturdy fundamentals and rising cash flows offered by secondary and tertiary markets are unquestionably attracting the eyes and capital of domestic and international investors alike. While the volume of sales transactions in large-cap markets was falling 16 percent during the first half of 2016, as Real Capital Analytics data shows, sales in small-cap markets maintained their upward momentum. Following an 8.5 percent increase in sales volume during the first quarter, second-quarter transactions rose 8.4 percent on a yearly basis, according to Realtors’ data.

The trend is corroborated by data on small-cap transactions from Boxwood Means, which points to total sales volume for the first six months of this year of $46.1 billion, a 1.6 percent year-over-year increase. Investment sales in small-cap markets are on track to outpace the record volume of 2015.

So which markets are these engines of growth, and what have been their catalysts? For many—like Austin, Seattle, Portland, San Jose and Denver—the technology sector is the catalyst that propels job growth and attracts employment and wages. For others—Houston, Dallas, Oklahoma City and Tulsa—the energy sector boom offered a path into the limelight. And for others still, population growth through in-migration—especially in the Southeast—and attractive locations have offered a winning combination. Metros in the latter group include Nashville, Louisville, San Antonio and New Orleans.

Building on a foundation of growing economies and solid fundamentals, these smaller markets have rewarded investors with higher yields. Whereas cap rates in the larger metros averaged 6.8 percent for all asset categories by mid-2016, cap rates in smaller markets averaged 7.2 percent. And while cap rates in gateway cities have been flat for the past few quarters, they continue to compress in the secondary and tertiary markets.

During the rest of 2016, investment in small-cap markets is expected to keep advancing. The main downside risks remain, such as the rise in long-term interest rates (though that seems fairly unlikely) and reduced bank capital for commercial development. With regulators training their sights on bank underwriting in the wake of Basel III’s rules for commercial real estate lending, financing availability has retrenched. For smaller markets, where bank funding provides more than half of debt capital, this may place a few speed bumps on the path to recovery.

George Ratiu is director of quantitative and commercial research for the National Association of Realtors. This article originally appeared in the October 2016 issue of CPE.