Forget Big Cities as Firms, Investors Set Sights on Smaller Markets

It wasn’t long ago when big city office skyscrapers and downtown apartment towers offering the proverbial live-work-play lifestyle were the gem in real estate but now they are taking a back seat.

Residents increasingly are opting for secondary and tertiary markets over metropolises with companies and investors following suit. Smaller areas are boasting population growth and big company relocations, and they are taking a bigger bite out of all commercial real estate deals, according to a Marcus & Millichap report.

A market like Florida’s Jacksonville is tertiary, Orlando is secondary and West Palm Beach primary. Texas’ Austin is secondary and San Antonio is tertiary, while Houston and the Dallas-Fort Worth area are primary. Charlotte, Las Vegas, Nashville and Phoenix are secondary, while Salt Lake City is tertiary and the Seattle-Tacoma area primary.

The coronavirus pandemic is playing a role as residents are seeking less densely populated areas where there’s less spread of the virus but that’s not the only factor. Firms and investors already were active in smaller cities in the years prior the outbreak, according to the report that focuses on migration and commercial real estate impacts.

Population net migration since 2000 into secondary and tertiary markets was 70% higher than in metros and that escalated to more than 200% higher since 2014. Big-name companies also are opting for non-gateway cities as Apple is working on an office in Austin while Amazon plans to open one in Nashville and Deloitte in Phoenix. And investors have taken note as last year 60% of commercial real estate transactions over $1 million were in non-primary markets, an increase from 40% in 2000.

Firms opt for smaller markets because they have lower overhead and real estate buyers because they have low entry costs, less competition from other investors, high cap rates and healthy yields.

All this has been good news for commercial real estate in non-metros.

Commercial Real Estate

Fundamentals such as vacancy rates and rent growth in secondary and tertiary markets are stronger than those of primary markets.

“As more residential and office space fills, other types of local real estate will benefit, from retail shopping centers to industrial facilities and even self-storage buildings,” the report authors wrote. “At a high level, assets in secondary and tertiary markets have recorded tighter vacancy and stronger rent growth than comparable properties in gateway metros, drawing investor attention.”

The apartment vacancy rate from 2007 to 2019 in secondary and tertiary markets went down 240 basis points to 4.3%, a bigger drop than the 100 basis point decrease to 3.9% in metros. In turn, the average effective rent during the same period went up 51%, a steeper increase than the 34% gain in metros.

Office real estate last year in non-metros had a roughly 12% vacancy, less than the 14% in metros. Industrial had a 5% vacancy, slightly less than the 5.5% in metros.

Coronavirus, Other Drivers

The 2017 Tax Cut and Jobs Act imposed a cap on state and local tax deductions, prompting household and corporate moves to more tax-forgiving states and cities.

In secondary and tertiary cities, families are finding quality of life at more accessible living costs that allow them to buy a home.

Metros like New York and Chicago are losing out on their smaller and mid-size counterparts as the two cities experienced a net out-migration of 600,000 residents since 2014.

Coronavirus exacerbated this trend as employees across the US working from home are opting for more comfortable suburban living, leaving behind cramped urban core apartment towers with high-end amenities now closed to residents to stop COVID-19 spread.

Case in point: New Yorkers put in 56,000 mail-forwarding requests in March with the U.S. Postal Service, more than double the monthly average, according to a report in The New York Times.

Facebook and Square are among some of the companies that have said a good portion of their staff can work from home indefinitely, no longer binding workers to big city employment hubs.

Firms are evolving much like households as they, too, are seeking more cost attainable markets with lower office rents and more developable land. They also prefer cities with universities, likely because this offers a diverse talent pool.

“These and other changes,” the report says, “to how and where people choose to live could extend well beyond the current concern of coronavirus infection.”

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