Multifamily investors, battle-weary from bidding wars that have battered returns in major coastal metros, have hit the highway for secondary and tertiary markets. Led largely by private buyers hunting for high yields and job creation, the frenzied investment activity is giving smaller cities across the country a ride on the capital wave that has flooded commercial real estate.

Apartment buyers and sellers closed nearly $40 billion worth of transactions in secondary and tertiary markets last year, nearly double the activity in 2004, according to Real Capital Analytics, a New York-based real estate research firm that tracks transactions $5 million and higher. To some degree, investors scouring smaller cities are reacting to high-priced primary locales where cap rates — a measure of a property's current cash yields based on the purchase price — have steadily dropped.

In the first quarter this year, for example, multifamily cap rates in primary markets averaged 5.3%, which is 120 basis points below average cap rates in 2004, according to Real Capital Analytics. Smaller markets posted average cap rates of 6% or more in the first quarter.

The bottom line: Equity providers are more receptive to secondary and tertiary cities than they were a few years ago, says Wayne Vandenburg, chairman and CEO of Chicago-based TVO Realty Partners, an apartment owner and operator with a roughly $1 billion portfolio in the Southwest, Midwest and Southeast. “The competition is so fierce that investors have to do things they normally wouldn't do to invest capital,” says Vandenburg. “So secondary markets have been very attractive.”

In February, TVO Realty partnered with New York investment manager Prescott Capital Management to acquire four parcels and nine apartment communities in mostly tertiary cities in Louisiana and Texas. At $110 million, the price represented a cap rate of about 6.5%, and executives with each company predict the booming energy industry and Hurricane Katrina rebuilding efforts will fuel job growth.

Prescott Capital invests on behalf of high-net-worth individuals who emphasize cash flow as much as, or more than, price appreciation, says Susan Stupin, a managing director at Prescott Capital. Smaller markets are often filling that need better than larger markets today. “You can find attractive opportunities in secondary and even tertiary markets,” she says. “But you need to be very focused on the underlying fundamentals and growth generators to get comfortable.”

The window of opportunity in secondary and tertiary locations, however, may prove shortlived. Apartment owners keep raising prices even while the cost of debt escalates, which makes potential investments much less lucrative. Typically, private buyers are using debt to finance 70% to 80% of an acquisition and are striving to hit internal rates of return (IRRs) in the mid- to high-teens, depending on the asset's quality and investment strategy.

“Private buyers who have been using a lot of leverage aren't getting the returns today they once were,” says Jack Cassidy, president and CEO of Omaha-based America First Apartment Investors. “Those are buyers we're going to see pulling away as interest rates increase.” America First owns some 6,470 units in 30 properties predominantly in the Midwest and Southeast.

Market bifurcation

So far, however, higher interest rates have failed to chill investment activity in secondary and tertiary cities. Through the first quarter of this year, multifamily investors spent $9.2 billion in smaller markets, according to Real Capital Analytics. That amount exceeded 2005's first-quarter dollar volume by $600 million.

The growing appetite for apartments in secondary and tertiary markets also has occurred alongside a REIT exodus from small cities. Many REITs continue to concentrate their portfolios in areas of the country that have well-defined population and job growth curves — typically coastal cities and interior markets like Phoenix, Dallas and Atlanta. Case in point: Chicago-based Equity Residential Properties Trust has all but abandoned the Midwest after souring the region's dismal employment and population outlook (see sidebar p. 28).

But even as REITs exit smaller markets, private investors are digging into secondary and tertiary markets to unearth signs of job growth. The most promising small markets are in the West, Southwest and South Atlantic regions. All are projected to outperform predicted nationwide employment growth of 7% through 2010, according to Reis Inc., a real estate data research firm in New York that tracks nearly 70 U.S. markets. Meanwhile, employment in the Midwest and Northeast is expected to grow by only 4.4% and 3%, respectively, over the same period.

Within the high-growth regions, Grubb & Ellis ranked Sacramento and Fresno, Calif., Portland, Ore., and Richmond, Va., as highly favorable apartment markets over the next five years. To compile the list, the brokerage firm took into account several factors: population growth, jobs, real estate fundamentals and other variables.

Bob Bach, national director of market analysis for Grubb & Ellis, also identified the Texas cities of San Antonio and Austin as attractive apartment markets. Indeed, in the Southwest, which Reis generally defines as Texas markets, jobs should grow by 13% over the next five years, bringing total employment in that region to roughly 7.6 million at the end of 2010.

New York private equity fund Niosi Doshi Cather Capital Partners is mining the South Atlantic region — states east of Texas and extending north to Maryland — where employment is expected to grow 7.7% to about 20.8 million jobs over the next five years.

Last year Niosi Doshi joined with St. Louis-based Michelson Organization, an owner and operator of some $400 million in commercial and multifamily assets, to buy apartments in the fast-growing communities of Murfreesboro, Tenn., Louisville, Ky., and Raleigh-Durham, N.C.

“Some of our strategies, we believe, are best executed now in secondary or even tertiary markets,” says Anthony Niosi, a principal with Niosi Doshi, which manages money for high-net-worth individuals. “It starts with an empirical view of how many and what kind of jobs are being created. We're not going to exclude big, small or tiny markets.”

Signs of a stalemate

Some experts, however, suggest that a disconnect between buyers and sellers threatens to stymie investment in smaller markets. What's behind the potential standoff? Since 2003, average multifamily cap rates in secondary and tertiary cities have dropped 150 basis points to 6% and 6.6%, respectively, according to Real Capital Analytics. The 10-year Treasury yield, meanwhile, has risen about 100 basis points in the past year to around 5.1%.

The narrowing spread between interest rates and cap rates is cutting into returns, making it tougher for buyers to justify some transactions, says Frank Stallworth, executive vice president of 1st Trust Bank in Memphis, a retail and mortgage bank that originated $140 million in multifamily loans last year. At the same time, sellers refuse to lower prices to adjust to the costlier debt, adds Stallworth, who anticipates originating roughly $115 million in apartment debt this year.

“We're in a little period of frustration,” he says. “Deals are wanting to be made, but sellers don't want to move up on cap rates. Meanwhile, buyers are saying, ‘This just isn't making sense like it did six to 12 months ago.’”

The same is true in Denver, where some apartment owners resist budging on prices that reflect cap rates of around 4%. And that's the case despite the fact that owners are still offering concessions in a market with a nearly 9% vacancy rate, reports David Baird, national director of multifamily for Sperry Van Ness, a real estate brokerage based in Irvine, Calif.

“Buyers are sitting back,” he says, “and it's going to take a rude awakening before owners in Denver get the picture that they're not going to get their asking prices.”

Multifamily investment activity in secondary and tertiary markets to date this year, however, is on schedule to match or surpass the high-water mark of nearly $40 billion recorded in 2005.

Yet that's not necessarily great news: The wave of capital crashing into smaller markets has made it tougher to identify worthwhile investment properties, says Jon Bell, vice president of capital transactions for Greensboro, N.C.-based Steven D. Bell & Co., a real estate investor and operator that owns some 18,000 apartment units in the Southeast.

The company, which invests on behalf of about 500 high-net-worth individuals, has acquired some $225 million worth of multifamily assets in each of the last three years with Memphis-based Covenant Capital, New York-based DRA Advisors and other equity partners. But Bell would like to double acquisition volume, and the money men stand at the ready, he adds, with open wallets.

“We essentially have institutional investors asking us, ‘How much money do you think you can prudently spend?’” says Bell, whose firm recently agreed to manage 6,600 units for Wilkinson Real Estate Advisors of Atlanta. “But a lack of good product at reasonable prices has been a constraint.”

Secondary ups and downs

Once investors gain a foothold in secondary and tertiary markets, what benefits do they derive? Beyond the higher yield potential, Bell says, overbuilding is rarely a problem because developers generally fail to notice smaller cities.

Additionally, the markets typically don't experience pronounced boom and bust cycles like some major cities. That provides investors with some assurance of stability, which subsequently allows them to use higher levels of debt to finance their purchase and generate extra yield, adds Allan Pollack, chairman of Chicago-based Providence Management Corp.

Pollack is a 30-year veteran of operating and investing in Midwest apartments, though his company recently liquidated all but 1,500 units of a 5,000-unit portfolio and plans to build new portfolios in Florida, the Southwest and select Midwest cities.

Pollack is quick to point out, however, that Providence Management acquired most of those Midwest holdings in 1999 with a partner who is ready to liquidate and harvest gains.

“There are capital sources we've found who want to be in other places, but that won't stop us from being in the Midwest,” he says. “There are still opportunities in the region.”

But investors also are quick to tick off drawbacks. Institutional investors usually display little interest in investing in secondary and tertiary markets, which may limit exit strategies.

Plus, smaller markets are prone to suffer from slow population and rent growth in addition to plodding price appreciation and new job creation.

In the first quarter of 2006, for example, only three secondary cities ranked among the top 10 markets that experienced the most growth in asking rents — Birmingham, Ala., Seattle and Phoenix, according to Reis. Smaller cities in the survey made up nine of the 10 bottom slots. For instance, asking rents remained flat in Minneapolis and Nashville and declined in seven markets to include Columbia, S.C., Denver, Omaha and Indianapolis.

Secondary minded

Cassidy of America First counters that rent increases, population growth, job creation and other variables can differ dramatically from location to location in the same market. In fact, in May the REIT paid $15.2 million for The Greenhouse, a 126-unit luxury apartment building in downtown Omaha that America First had managed for more than a year.

In addition to the asset's quality, America First keyed on some $3 billion of commercial investment that has poured into downtown since 1999, resulting in a new arena, a new performing arts center and other projects that are attracting dwellers to the city's core.

“Time will tell whether we'll get the kind of growth we would in perhaps other cities,” Cassidy explains, “but we feel that right now it's a very attractive investment.”

Joe Gose is a Kansas City-based writer.

Searching for growth in down-and-out Midwest

While the nation continues to rebound — close to 2 million jobs were created last year — much of the Midwest is struggling with a grim employment landscape. U.S. automakers continue to flounder. In many cities, job creation will fall short of the national average over the next five years, as will population growth.

Equity Residential Properties Trust, based in Chicago, underscored the heartland's economic heartache earlier this year when it decided to virtually abandon the region by putting its lower-end, 27,390-unit Lexford division up for sale.

The REIT, which owns and operates nearly 200,000 apartment units in primary markets across the country, paid $730 million for Lexford in 1999. The portfolio is spread out across the Midwest and Southeast, and Wall Street analysts anticipate the assets to fetch $1 billion.

According to David Neithercut, president and CEO of Equity Residential, who discussed the Lexford sales with analysts in an early May earnings report, the planned disposal is the latest step in the REIT's 5-year-old strategy to exit small cities and concentrate on acquiring and developing apartments in core markets from Boston to Southern California.

“Our largest 20 markets now comprise 86% of our net operating income, and that's up from 65% in 2000,” Neithercut told analysts. “We continue to move more capital into those markets that we think will provide higher total returns.”

According to forecasts by Reis Inc., total employment through 2010 will remain flat in Cincinnati and Detroit and will grow less than 5% in Cleveland, Columbus, Ohio and Milwaukee. Only Chicago, which is expected to grow jobs by 6%, is near the predicted national average of 7%.

None of those markets will meet or exceed the national average of 5% over the next five years, according to Reis forecasts. Moreover, Detroit will see declines while Cleveland will grow less than 1%.

Buyers can find robust growth within Rust Belt submarkets, however, particularly in areas with economic growth engines, says Susan Stupin, a managing director of Prescott Capital Management, a New York investment manager. A fledgling biotech industry in Grand Rapids, could drive significant growth in the market, she says.

Stupin says REITs and institutional investors exiting, or avoiding, the Midwest leave openings for private capital. “You can find significant growth in some of these markets,” she says. “Even in Michigan, you have economic generators that are purely separate from the auto industry.”
Joe Gose