Challenging Misconceptions: Research Makes Compelling Case for Investing in Smaller Markets
by Ryan Swehla
Cities such as Bakersfield, Calif.; Orem, Utah; and Loveland, Colo., aren’t typically top of mind for institutional investors. But groups that once bypassed such secondary and tertiary markets in favor of major metros are now putting these smaller markets on their radar.
Institutions have traditionally viewed commercial real estate investment through a fairly narrow geographic scope, with their sights firmly set on acquiring assets in primary markets. Even as competition and a search for better risk-adjusted yields pushed investors to expand their focus beyond the top 10 metros, they have typically moved cautiously and targeted large, fast-growing secondary markets.
That investment thesis is now changing, thanks in large part to greater transparency and historical data that present a solid business case for the strong performance of assets in smaller secondary and tertiary markets. Graceada Partners recently conducted an in-depth analysis of economic metrics and real estate fundamentals in workforce housing and industrial sectors in secondary and tertiary markets versus primary markets in the western United States. The findings uncovered surprising results on the vibrancy of local economies, outperformance in key real estate market fundamentals and greater stability across the past 20 years.
When an institutional investor hears the term “secondary and tertiary markets,” several concerns automatically come to mind, including lack of liquidity; less economic diversity; and overall slower growth, particularly during economic downturns. Data-driven research is debunking many of those long-held market misperceptions.
Vibrant local economies
Secondary and tertiary markets in the West are economically more robust and, importantly, less volatile than primary markets. Analysis of data from Oxford Economics and the U.S. Bureau of Economic Analysis of 12 secondary and tertiary markets found that the sample set exhibited stronger GDP growth, income growth and job growth compared to bigger primaries, such as San Francisco and Los Angeles, over the 20-year period from 2002 to 2022.
Economic growth: GDP growth averaged 5.05 percent in secondary and tertiary markets — 36 basis points higher compared to primary markets. During the global financial crisis, GDP growth in secondary and tertiary markets was 300 basis points better than in primary markets, and GDP growth also outperformed primary markets during the COVID pandemic.
Job growth: Employment was consistently better in secondary and tertiary markets, even during the GFC and during the pandemic. The annual average job growth, at 1.76 percent over the 20-year period, is almost double that of the 0.92 percent in primary markets. Secondary and tertiary markets also posted consistently lower unemployment, with an average of 6.04 percent, which is 35 basis points below primary markets.
Income growth: Household income growth in secondary and tertiary markets is on par with primary markets. However, growth in the smaller markets tends to be more stable, with fewer peaks and valleys as compared to primary markets. During the GFC, primary markets had more severe income declines, and during the pandemic, secondary and tertiary markets posted continued positive income growth, whereas primary markets had negative income growth.
People and diverse economies fuel growth
The perception that smaller metros are more likely to be so-called one-mill towns that are more prone to boom-and-bust cycles doesn’t hold up in the West. Two key reasons why secondary and tertiary markets are outperforming are their diverse economies and population growth, including net in-migration.
Among the dozen Western cities Graceada analyzed in California, Utah, Nevada and Colorado, all had broadly diversified economies, with most having no single sector greater than 17 percent of GDP. The two exceptions are Sacramento and Colorado Springs, where the government represented 22 percent and 24 percent, respectively. In comparison, more than 50 percent of GDP in the San Francisco Bay Area is dependent on technology.
Fresno, for example, has a broad cross-section of industries ranging from manufacturing, transportation and agriculture to business and professional services and real estate. Among the top employers in Fresno County are major firms such as Cargill, Foster Farms, Pelco, Kaiser Permanente and Amazon, among others.
Population growth is one of the biggest drivers of demand for real estate, and secondary and tertiary markets produce consistently higher net population growth, with an annual average of 1.3 percent versus nearly flat growth in primaries at 0.2 percent. Primary market population growth exhibits almost twice the volatility of secondary and tertiary markets and registered a decline in seven of the 20 years analyzed.
Another important point to highlight is that while the pandemic may have accelerated population growth out of primary markets and into smaller metros, data show a consistent and positive trendline for western U.S. secondary and tertiary markets over the last 20 years with no pandemic-induced spike. That suggests that these are long-term expansion markets that are receiving in-migration from other parts of the United States and not just from neighboring primary markets such as San Francisco or Los Angeles.
Solid foundation for real estate
That strong economic base, and growth — in people, jobs and incomes — drives demand for commercial real estate. The other side of the equation is supply. Another common misperception for secondary and tertiary markets is that there is abundant land and fewer barriers to entry for developers, which creates a greater risk of oversupply.
Analysis of CoStar data clearly shows greater volatility in supply and demand in primary markets when looking at net absorption. The likely reason for that is that there is more availability of capital for development in primary markets, whereas in secondary and tertiary markets, development tends to be limited to private capital. The relatively good balance between supply and demand dynamics is another factor contributing to outperformance in market fundamentals.
A snapshot of current market research shows that secondary and tertiary markets are continuing to follow historical trend lines. For example, a third quarter 2024 research report on Sacramento’s multifamily markets published by Colliers showed a strong recovery in 2024. Demand outpaced supply by 1,000 units during the first three quarters, with vacancies at 5 percent and effective rents growing at an annual rate of 1.4 percent, pushing average rental rates past $2,000 for the first time ever.
Despite softening in many national industrial markets, vacancies in Colorado Springs dipped lower to 4.6 percent during the third quarter, with newer class A space in particular being in short supply. Asking rents grew at a modest 1.2 percent, while cap rates averaged between 6.5 and 7 percent, according to NAI Highland.
Expanding investment box
Targeting secondary and tertiary markets fits into what has been an ongoing trend in strategy for many institutional investors. Over time, institutions have been expanding their traditional view of what is considered to be the accepted “investable universe” and are continuing to move into new property types and subtypes, as well as new geographies.
A number of factors are opening pathways into new markets. The markets themselves are maturing, and there is more transparency and data. Institutions also have developed their own processes for overcoming misperceptions, identifying opportunities, underwriting investment assets and building the infrastructure and expertise to successfully execute investments in new areas.
A clear example of that expansion is the move beyond the traditional core property types and heavy concentrations in office into a variety of alternatives, such as self-storage, manufactured housing and single-family rentals, among others. In the early days for each of these new subsectors, there was a litany of reasons (and misconceptions) why such strategies or focus areas were “noninstitutional” or not investable. Each time, those objections were ultimately overcome, and the first investors into the space benefited from lack of institutional competition. That same trend is now under way in secondary and tertiary markets, and institutions have the potential to capture similar first-mover advantages.
