When P. Evan Farahnik, principal of real estate investment and acquisitions firm StarPoint Commercial Properties, LLC, first entered the retail real estate arena 15 years ago, he was a firm believer in investing in primary markets only. Because StarPoint's headquarters are located in Beverly Hills, Calif., Farahnik felt that Los Angeles was his best bet, both because he and his staff were familiar with the area and because as a major metro center, the city offered better yields.

But in the past five years, as the market started to heat up, the percentage of properties in secondary locations within the firm's portfolio has grown from 0 to 35. And looking forward, Farahnik plans to build on this strategy, noting that the fundamentals in many secondary markets are as strong as those in the metros.

“We see a lot of centers in secondary locations with retail occupancy at or greater than 90 percent,” he notes. “As the primary markets have gotten extremely crowded and expensive, more and more people are going into [smaller areas].”

In addition, technological advancements such as the web-based geospatial data tool Google Earth, first launched in 2004, have allowed real estate executives to get information on markets well outside the limits of their home base. It used to be that investors would stay away from any property that was farther away than half a day's drive from their office, says Philip D. Voorhees, senior vice president for retail investments with brokerage firm CB Richard Ellis.

Now, if they are able to fly to and from the location within a day's time without changing planes, they have no problem putting their money into it.

“The way we do business has changed a lot in the past few years, you can get sales comps and other relevant information on basically any place you want,” says Voorhees, who identifies 2004/2005 as the start of the drive toward secondary locations.

“And from there, it's a word of mouth thing — when Las Vegas first started going, everybody decided they needed to be in Las Vegas. And now the same thing is happening in places like New Mexico.”

Lately, even smaller markets have been getting more attention, according to Richard Walter, president of Faris Lee Investments, an Irvine, Calif.-based advisory and brokerage firm specializing in retail real estate. “In order to get market share, people now have to go into tertiary locations,” he notes.

But the competition in smaller areas is heating up and it's becoming harder to find quality assets. In the first quarter of 2007, the average cap rate for properties in first-tier and second-tier locations was the same at 7.3 percent, according to REIS, Inc., a company that tracks commercial real estate statistics, while the cap rate for third-tier markets stood at 8.2 percent.

Compare that with the first quarter of 2005, when the average cap rate for properties in first-tier markets was 7.3 percent, but second-tier locations had a cap rate of 8.1 percent and third-tier ones a cap rate of 8.5 percent. (REIS defines first-tier locations as those with the greatest amount of deal volume.)

The weighted price per square foot also showed a greater increase in secondary markets in the past two years than in primary ones — the figure rose 16.6 percent to $196.67 in the first quarter of 2007, from $168.70 in the first quarter of 2005. In primary markets, the increase was 13.7 percent to $244.01, from $214.54.

“With so much money out there today, people are looking at every crevice they can find,” says Garo Kholamian, president of GK Development Inc., a Barrington, Ill.-based real estate acquisition and development company that specializes in buying and repositioning properties in non-metro areas, including Cedar Falls, Iowa, Greeley, Colo. and Great Falls, Mich.

“There is definitely more competition today than there was [a few years back].”

In addition, though the market itself might be attractive, properties in secondary and tertiary locations are often so sub-par they might never live up to investors' expectations, according to Voorhees.

“Some of them may at first look like good value, but they may be in the same condition as when they were first built in the 1960s or 1970s, whereas properties in primary markets are either more recent or have been updating frequently,” he notes. “If the property seems less expensive than normal or has a higher cap rate, there's usually a reason for that.”

But brokers say that by choosing the right locations and being careful about pre-leasing the centers, real estate professionals can still get healthy returns from going into secondary and tertiary markets.

Tread carefully

The real estate industry is still split on what constitutes a secondary or tertiary market. REIS, Inc., for example, defines the markets based on transaction volume. The areas on the bottom of the scale fall into the secondary or tertiary category. CB Richard Ellis, on the other hand, looks at population density — a trade area with less than one million people is considered to be a secondary location, those with less than 400,000 people a tertiary one. Some companies might weigh additional considerations, including projected job growth and migration patterns.

But on the development side, what constitutes a secondary location might also depend on whether the company is private or institutional. “An individual developer would find Hartford, Conn. a primary market, but a [REIT] would not,” says Joseph French, national director of retail with real estate investment brokerage firm Sperry Van Ness. “To them, the major markets are New York, Chicago and Miami.”

Regardless of the varying definition, everyone agrees that secondary, and in some cases, tertiary markets, currently offer good returns, particularly if yours is the only retail center there. For example, a few years ago, GK Development bought Columbia Mall in what it considers a secondary location — Grand Forks, N.D. The town has a population of 61,585 people within a 10-mile radius. As it turned out, the 622,000- square-foot property is one of only four malls in the state of North Dakota.

After the acquisition, a mere announcement from GK that it was adding a food court to the mall boosted sales. When the food court, along with a new children's play area, were completed, sales at the center rose from $235 per square foot to more than $300 per square foot, an overall increase of more than 28 percent.

“Very often, we are the only mall in the market, so our ability to get people's attention is much greater,” says Kholamian. “Our marketing and redevelopment efforts are much better received than in some major metro areas.”

That is exactly what shopping center REIT the Macerich Company, which operates 73 regional shopping centers, assesses when it considers putting more money into a secondary market.

“It's about the opportunity to create value — is the market demanding something new? Is there a pent-up demand that hasn't been met?” says John Genovese, senior vice president of development with Macerich.

An example would be the Fashion Fair Mall in Fresno, Calif., which Macerich considers a secondary location. Because the company felt that the center had the potential to bring in more money, it invested in a major remodeling in 2003, adding on a lifestyle component, fitting in restaurants and bringing in higher profile tenants, including Sephora, Lucky Brand Jeans and Urban Outfitters. Today, the shopping center is 100 percent occupied.

But the fact that there are so few properties and deals in secondary markets also leads to incomplete or too old data for investors, warns Voorhees.

In some cases, the sales comps and yield information may be a few years old. Plus, there is the danger that a competitor will come in and steal your already limited foot traffic. “You are taking more of a gamble in terms of what might happen in the future,” he notes.

There are also issues with the relative lack of socioeconomic diversity, particularly in tertiary markets, according to Sam Chandan, chief economist with REIS. Consumer profiles, including income levels, education levels and employment opportunities, are not as diversified in smaller markets as they are in major metro areas.

Therefore, if the economy takes a hit, retail centers in secondary and tertiary locations are at a greater risk than those in the cities since everyone within the trade area is likely to be affected, says Chandan.

That could become an issue sooner rather than later. “In recent months, there has been a more modest net absorption of retail space and it's our expectation that the vacancy rate will rise modestly by the end of the year,” he warns.

Some REIT analysts share Chandan's concerns. Last month, Jonathan Litt, of Citigroup, downgraded CBL & Associates Properties, Inc. because a significant portion of its shopping center portfolio is in secondary markets.

“We worry that CBL's markets could be the first that retailers exit in tougher times and the last to recover when the tide turns,” Litt wrote. CBL, however, did not return calls seeking comment.

How to deal

Joint ventures can be a hedge when venturing into smaller markets because the risks are split between two or more parties. Developers partnering with institutional investors should concentrate on mega-projects in big growth states, says French. “If they have a billion dollars to invest, they won't want to make hundreds of deals valued at $1 million each,” French says.

In addition, grocery-anchored shopping centers and discount retail centers are better able to weather economic downturns, so it makes sense to invest in those kinds of properties, rather than lifestyle centers or regional malls, according to Farahnik.

Another viable approach is repositioning. With an acquisition, the addition of entertainment venues, including bookstores, theaters and restaurants, will bring more people into the center.

“In smaller markets, there is a shortage of them and they are very well received, so we put an emphasis on trying to bring them in,” says Kholamian.

When it comes to ground-up development in tertiary markets, French strongly recommends signing up a dominant anchor tenant in the pre-leasing stage such as a Wal-Mart Supercenter. Without a good anchor, drugstores, big boxes and other service retailers will be reluctant to sign a deal, while most fashion and lifestyle retailers simply won't go into tertiary locations.

“There is a clear risk if you are developing in a tertiary market without a Wal-Mart that they could come in somewhere else, create a new market there and that could be your undoing,” French says.

He also recommends developers stay away from areas that have notoriously burdensome regulations for governing retail real estate, like the Northeast, where the risks of building in a non-prime market are compounded.

“If you are willing to move into those markets, you'll need double digit returns and you will need to be able to figure out how to get them,” says French. “Both developers and retailers are getting more adventurous looking at smaller markets. But it's a game.”