The Case for Investing in Targeted Secondary Markets

A quick thought exercise: Why do office buildings in markets such as Indianapolis, Columbus or St. Louis trade at higher cap rates than New York City, Los Angeles or San Francisco? Raise your hands if your first instinct was because they carry more “risk.”

That’s the first and simplest answer that most people provide, which makes a lot of intuitive sense. Those major markets are preeminent technology, media and financial hubs with global investment demand. Liquidity is almost always available and if you lose a tenant it’s likely that another one exists behind them. Not to mention, rents can go through the roof (and my have they ever)!

But take that thinking to the next level… All those assumptions are already built into the price. The low cap rate takes that margin of safety out of the deals. The mere fact that you can acquire properties in non-coastal markets at higher yields fundamentally means that you have more cushion to withstand a negative market environment. In the current market, everyone can look like a genius when underwriting mistakes and margins of safety are papered over by consistent growth.

So let’s hit the data, below is a sampling of historical rent growth and occupancy in San Francisco and Indianapolis, courtesy of Cushman and Wakefield research.

Q1 2019 Indianapolis and San Francisco Office reports compared

What jumps out? The most obvious is that San Francisco has seen percentage rent growth outpace Indianapolis. But you knew that before looking! Without that rent growth, one can’t turn a 5% cap rate into a 15% total return, it’s simply not possible.

You know what else? Current San Francisco rents are just slightly beyond their all-time peak. Which means? When rents came down, they came down a lot. Contrary to popular belief, stability is not a hallmark of primary markets. When things are going well, they can go very, very well. But when the economy softens, look out below.

Take another example with Manhattan’s office market. Manhattan is actually above average in occupancy and yet rates have basically flattened out the last few years.


Meanwhile, while St. Louis is below average in occupancy, rents are also very stable.

Imagine that as an investor in targeted secondary markets: Stable rents, and higher initial yields. When someone asks why we look where we do, it’s because investing isn’t just about catching the next big wave, it’s about avoiding the rocks when the wave eventually breaks into shore.

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