What a difference a few years makes. The quick and steep rise of real estate prices in cities like Boston, New York and LA has priced out many investors, who are now chasing higher yields in secondary markets like Philadelphia, Seattle and Minneapolis.
Not only are secondary markets more affordable, but they also offer an opportunity for smaller-scale investors to buy Class A buildings for a fraction of the cost of Class B properties in primary markets.
But in their pursuit for higher yields, are these investors just chasing their tails?
Simply, do Class A properties in secondary markets really provide greater risk-adjusted returns than Class B buildings in primary markets?
Research out of MIT’s Center for Real Estate Development decided to investigate the question further. Students began by using CoStar data to classify a property as either a Class A or Class B asset. 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 or lifestyle 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.
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.
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 the 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, researchers 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.
Of note, Class B office buildings in primary markets were hit harder during the recession than Class A office buildings in secondary markets (likely a result of the capital crunch and oversupply in core markets); but Class B buildings in primary markets rebounded much more quickly than Class A properties in secondary markets.
A few other noteworthy findings:
- During the “growth period” of 2005 to 2007, Class A multifamily properties in secondary markets experienced an average total return of 17.5%; Class B buildings in primary markets produced an average return of nearly 24.5%.
- During the “trough period” of 2008 to 2010, Class A multifamily buildings in secondary markets had an average total return of 1.35%, compared to an average -2.20% return for Class B multifamily properties in primary markets. This suggests that multifamily housing in primary markets is more susceptible to downturns in the economy.
- During the “recovery phase” of 2011 to 2013, Class A multifamily buildings in secondary markets resulted in an average total return of 14.17%, versus an average 13.11% return for Class B multifamily properties in primary markets.
These results came as somewhat of a surprise to researchers; the findings indicate that multifamily housing in secondary markets is 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.
- Although Class A multifamily properties in secondary markets outperformed Class B properties in core markets for the majority of the study period, the returns produced during the growth phase outweighed slower growth in the other years.
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 provided higher returns than Class B industrial space in core markets over the period of 2005 and 2013.
The authors conclude: “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.”
As the old adage goes – location, location, location!
It’s the mantra we follow at MWest Holdings. Our portfolio consists of more than 2 million square feet of residential and commercial property across the U.S. We specialize in enhancing classic, core-plus and value-add opportunities. Occasionally we’ll pick up opportunistic investments, particularly those that have historic architecture. But regardless of the class and asset type, one thing remains the same: we almost always invest in primary markets. It’s a strategy that’s worked well for us to date, and if research is any indication, it’s a strategy that will help us preserve long-term value for our shareholders.
To download the full MIT study, visit: https://dspace.mit.edu/handle/1721.1/92606