SCI Real Estate Investments has traditionally targeted acquisitions in primary markets, including its hometown of Los Angeles. But when cap rates in Southern California fell to 6% about two and a half years ago, the firm began to explore secondary markets such as Albuquerque, Fort Lauderdale and Denver.

The strategic shift, considered at the time to be somewhat contrarian, has only intensified. “We're going to the secondary markets while the big boys slug it out in the primary markets,” says Scott Derrick, SCI's senior vice president of national acquisitions and dispositions. The real estate investment firm specializes in tenant-in-common (TIC) structures, and has a portfolio of commercial and multifamily properties valued at more than $700 million.

With cap rates in Los Angeles dipping as low as 3.8% in the past year, SCI's interest in secondary markets isn't likely to wane anytime soon. In fact, of the $400 million SCI plans to invest in apartment properties in 2005, about 65% of those investments are likely to occur in secondary markets, Derrick notes.

So far, that strategy has yielded positive results. Last December, SCI acquired an apartment property in Kissimmee, Fla., for $15 million, and turned around and sold it to a condo converter in March for $20 million

As prices continue to soar in top metros such as Chicago and New York, more and more buyers are pursuing higher returns in secondary markets — generally defined as having a population ranging from 1 million to 3.9 million. Cap rates in primary markets range between 4% and 6% compared to cap rates ranging from 5% to 8% in secondary cities.

Brisk transaction volume

About $15.6 billion in apartment properties sold in the first quarter of 2005 compared with the $9.1 billion that traded hands during the first quarter of last year, according to Real Capital Analytics. The buying frenzy is most evident in major metros. In Manhattan, apartment property sales over the past 12 months through March totaled $2.05 billion at an average cap of 4%, or $253,208 per unit. Those prices are about three times higher than secondary markets such as Las Vegas where $2.15 billion worth of apartment properties sold during the same period for an average cap rate of 7.1% or $78,393 per unit, according to New York-based Real Capital Analytics.

“A few years ago, I was investing primarily in the Bay Area, but I was priced out of the market,” recalls Peter Harris, a partner with the Oakes Group, a private real estate investment firm based in San Francisco. The firm targets Class-B and C apartments, which are older and include fewer amenities than Class-A assets.

Harris is finding ample deals in secondary markets such as Cincinnati and Dayton, Ohio, with cap rates well above the 5.7% mark that San Francisco has averaged during the past year. For example, Oakes Group purchased the 87-unit Montgomery Road Apartments in Cincinnati last November for $1.9 million. The Class-B property sold at a 9% cap rate. According to Harris, there is no shortage of 9% and 10% cap deals when buying B and C properties under 100 units.

A distinct advantage secondary markets have over primary markets, experts say, is a larger inventory of Class-A properties featuring amenities such as swimming pools, volleyball courts and parking garages. Primary markets tend to have a limited inventory of Class-A properties due to barriers to new construction such as high land costs.

Houston-based Creekstone Partners recently closed on two Class-A properties with the purchase of the 284-unit Reserve at Walnut Creek in Austin and the 356-unit Alexan Castle Pines in Castle Rock, Colo. Both properties are loaded with amenities such as fitness centers, a business resource center and a resort-style swimming pool complete with waterfall.

A gamble worth taking

The returns in secondary markets are higher, but so are the risks. Smaller markets are more susceptible to changes in job markets, especially if they rely heavily on one or two industries. If there is a downturn that affects one of those industries, it can have a significant negative impact on the apartment market.

In some cases, vacancies in slumping markets have risen from 3% to 20% within 12 months, notes David Rich, national director of multifamily at Sperry Van Ness in Irvine, Calif. “The risk is reflected in the returns that these properties yield. Investors have to remember that,” he says. “It's like going out and purchasing a junk bond. You're getting a higher return, but it also is a much more risky asset.”

Investors also need to consider their exit strategies. Even though secondary markets are reveling in avid investor interest today, only time will tell whether that buyer demand — and competitive pricing — will exist in the future.

SCI executives perceive secondary markets to be less risky than primary markets, where lofty pricing may be difficult to sustain. Condo conversions have been driving up pricing in major metros such as Miami and Washington, D.C. “We feel that there is a substantial risk if the condo conversion market goes away,” Derrick says.

In addition, SCI is mitigating risk by buying secondary market properties at below replacement cost — on average about $90,000 per unit compared with the current replacement cost that ranges between $95,000 and $110,000 per unit.

Secondary markets also are benefiting from a deluge of investment capital looking to find a place to land. Real estate remains a safe harbor amid ongoing volatility in the stock market.

Timing a turnaround

The key for many investors is to identify secondary markets that are poised for economic recovery. “We have had an outside interest in St. Louis for quite some time, but there has been a noticeable pick-up in the last 18 months,” says Mike Hanrahan, a vice president at Colliers Turley Martin Tucker in St. Louis. National players such as Boston-based TA Associates, New York-based Sterling Equities and Chicago-based Capri Capital have all bought apartments in metro St. Louis in the past year.

In fact, about $200 million in apartment complexes were sold in the St. Louis market in 2004 and transaction activity is on a similar pace for 2005. That activity is well above the norm of about $125 million in annual apartment sales, Hanrahan notes.

The St. Louis market was hard hit by the economic downturn, but it is showing signs of improvement. The unemployment rate dipped to 6% in March of this year after hitting a high of 6.9% in July 2004. Still, the apartment vacancy rate registers 12%, nearly twice the norm of 5% to 6%. But an improving job climate and higher interest rates should cause the booming home buying market to slow down, says Hanrahan. “I think we are on a path to a more normalized market.”

SCI's strategy has been to target secondary markets such as Denver that are on the cusp of a recovery. The firm typically goes into a secondary market and buys properties that — including current concessions — generate cash-on-cash returns of 7% to 8%. When those one- to two-month concessions disappear, the returns rise significantly to 10% to 12%. That is an attractive investment, especially compared to deals in primary markets where returns now range between 4% and 5%, notes Derrick of SCI.

Condo craze alters playing field

One reason for the lofty prices in primary markets is a flurry of condo conversions, according to Linwood Thompson, managing director of the national multi-housing group for Encino, Calif.-based Marcus & Millichap. “Investors want to maximize yields, and it is very tough to do that in markets where you have to compete against condo converters,” Thompson says.

In Miami, 77% of the apartment transactions in the past year involved sales to condo converters. The cap rates on those deals averaged 5.9% and the average price was $133,295 per unit, reports Real Capital Analytics. In comparison, properties throughout the Southeast sold for an average price of $82,531 per unit and an average cap of 6.9%. The active Miami market has pushed buyers into smaller markets such as Fort Lauderdale, Tampa and Orlando in search of lower prices.

On the radar screen

Some of the favorite alternative markets for buyers, according to Real Capital Analytics, include Norfolk, Va., Memphis, Tenn., and Southwest Florida. Areas such as Las Vegas and Austin, Texas have been hot for the past 12 to 24 months, while other markets such as the Carolinas are just beginning to see interest pick up, Thompson says. The common thread among all of these markets is a growing population base. In Florida, for example, the population jumped 6.5% between April 1, 2000 and July 1, 2003 to reach 17 million statewide. During that same period, Florida's population among persons 65 and older increased by 17.6%, according to the U.S. Census Bureau.

Meanwhile, competition in Los Angeles and San Diego is prompting investors to move further into Southern California to markets such as Long Beach and the Inland Empire. The same phenomenon is occurring in Arizona. As competition for properties in Phoenix intensifies, buyers are searching for values in areas such as Mesa. SCI recently purchased the 392-unit Stone Canyon Apartments in Mesa, Ariz., for $37.5 million. The Class-A property sold at a cap rate of 6%.

Beyond secondaries

Some investors are even turning to tertiary markets to find deals. “We've seen a compression in cap rates over the last year that has started to make these secondary market deals look less attractive,” says Rich of Sperry Van Ness. As a result, some investors are moving into even smaller, tertiary markets where caps have been averaging between 7.5% and 9%.

In Breckenridge, Texas, Sperry Van Ness brokered a deal on a 42-unit apartment building that sold for $800,000. The same amount of money in Dallas for example, would buy only about 20 units. “So, you can get a lot more for your money, returns are higher, and costs per square foot are significantly below replacement cost,” Rich says.

During the past 18 months, Marcus & Millichap has brokered apartment deals in more than 100 different U.S. cities ranging from Tuscaloosa, Ala. to Middleton, Wis. “The general perception is that secondary and tertiary markets are more liquid than people thought they were,” Thompson says. “We have no problem marketing assets.”

Beth Mattson-Teig is a freelance writer based in Minneapolis.

AVERAGE MULTIFAMILY CAP RATES: PRIMARY VS. SECONDARY MARKETS APRIL 2004-MARCH 2005
Primary Cap Rate Secondary Cap Rate
Chicago 7.0% Columbus, Ohio 8.6%
Boston 6.0% St. Louis 7.8%
Los Angeles 5.8% Milwaukee 7.8%
San Diego 4.8% Hartford, Conn. 7.5%
Manhattan 4.0% Austin, Texas 6.7%
Source: Real Capital Analytics