For Graceada Partners, a value-add investor which has been operating in secondary and tertiary markets in California since before the Covid-19 pandemic, gig economy and freelance workers are institutionalizing these outpost economies. NAREIM speaks with Ryan Swehla, principal and co-founder, on the opportunities that have led to the firm’s reported net IRR of 67% and net equity multiple of 1.94 across nine realized assets.
What is the opportunity in secondary and tertiary markets?
What we’re seeing is this idea of the outpost economy, which is a concept of a more dispersed work environment with an emphasis on flexibility across the United States. People are moving out of primary markets for a high quality of life in secondary and tertiary markets. High quality of life is a key component, because this is not being driven by, “My employer needs me in Milwaukee.” This is being driven by, “I want to live in Boise and I no longer need to be tethered to my office.” Pre-pandemic, there was already a trend toward remote work. It wasn’t a huge part of the work environment, but its growth was significant. One driver is remote work, and the other one is the gig economy. The gig economy didn’t exist 10 or 15 years ago. Today, with Upwork and other similar platforms, freelance and consulting work have become more mainstream. The Covid-19 pandemic accelerated this trend.
What are the underlying factors driving the move to outpost economies?
The broader theme is that we had existential questions, such as, “What am I doing?” “Where am I going?” “Is this where I want to be?” “Is this what I want to be doing?” Many people sheltering at home had questions about work-life balance. “Is this the work-life balance that I want?” “Is this what I want for my family?” An outpouring of that for many people was getting up and moving. We have heard of the term the Great Resignation, but my business partner Joe Muratore calls it the ‘Great Renegotiation.’ We’re in the tightest job market we’ve been in in decades. Employees have the upper hand in negotiation. New business licenses are the highest they’ve been on record, almost hitting 6 million in 2020. That’s almost double the historical average. The businesses that have low propensity to have additional employees — the gig economy — are the ones driving that jump. (see Exhibit 1) What that tells us is the gig economy is driving these changes. There are more people moving out of the labor market because they’re now becoming independent contractors. For others already on the cusp — those who hated their commutes or couldn’t buy a home they wanted for their kids — the pandemic accelerated the move. This group — perhaps 10% to 15% of people who were working in primary markets — made a permanent move to secondary and tertiary markets. They bought a home and relocated their family. This is the group that we’re talking about.
Are the secondary and tertiary markets winning at the expense of primary markets?
I would say this is a story of secondary markets being winners, but it’s not a story of primary markets being losers. We’re only talking about a 10% to 15% shift. That’s neither seismic nor secular; that’s just a small percentage of people.
This is transformative for working age parents, the early 30- through 50-year olds who comprise most of the workforce, who want a better work-life balance.
There are three flexible work modes. The first is hybrid work. You can work from home a couple of days a week but you need to go into the office. The second is remote or gig work, where you’re truly geographically distant. And then the third is corporations opening up satellite offices in smaller markets. The secondary markets nearby the major metros are seeing a lot of activity since hybrid work is an alternative. Even if employees go back to the office part time, they can handle the commute. It’s the Salt Lakes, the Denvers, the Boises, that are getting more of either the gig/remote work or satellite offices that are opening up in those markets.
Which markets are you excited about?
We’re going to the markets with a high quality of life and lower relative cost of living. These are places where people are choosing to move. Interestingly, more people moved within California, than out of California. Even though population actually declined in California in 2021, more people migrated within California than out, and where they moved was inland.
We’re certainly excited about the growing inland markets in the Western United States. We are particularly interested in the secondary and tertiary markets there — those where institutional capital has had a hard time accessing due to small average asset size. Growth and momentum are there, but it has be almost exclusively the purview of private capital. We love operating in Martinez versus Oakland, Carmichael versus Sacramento, Fort Collins versus Denver.
What is the size of the opportunity?
Fifteen years ago, multifamily was not considered an institutional asset class. It is now the fourth major asset class. Today, data storage, self-storage and single-family rentals are all getting institutionalized. When you look at secondary and tertiary markets as a broad segment, it’s pretty significant. The greater Northern California secondary and tertiary markets alone have almost $500 billion in real estate value, according to Costar. So the broader secondary and tertiary markets nationwide represent a substantial market.
It’s a lot like single-family rental; we’re not creating a new asset class. Single-family rentals were mom and pop and they are becoming institutionalized. Outpost markets have been almost exclusively under private ownership. The market is mature.
Everyone wants to get in, but there’s only so much scale.
Institutional capital wants large deal sizes. You will not find large deals in secondary and tertiary markets. Our operating size is $10 million to $50 million. We’ve looked at some that are $70 million and it’s very hard to find deals that are much larger than that. So, by definition, you are operating in a smaller asset size.
What happened pre-Global Financial Crisis (GFC) is that institutional capital started to get into these markets because they were looking for yield when the primary markets got too expensive. The problem is that institutional capital helicoptered into those markets and they lost the most. They were buying the largest assets in the market. By definition, they’re going to have a hard time finding their exit buyer for those assets.
The big difference between the GFC era and today is we do not rely on institutional capital to be the exit strategy. Often our buyers may be private buyers. We rely on our deep, entrenched market knowledge, but we operate our value-add strategy at an institutional sophistication. We’re able to find a lot more opportunities for value than less sophisticated regional competitors — the parochial ‘cowboy.’
Which asset types are most attractive?
There’s huge demand for multifamily, single family for sale as well as single-family rental. Because of that demographic move toward family formation, we think single-family rental will continue to be a robust market. The big driver for those is supply and demand. I don’t think we’re going to see the crazy rent increases that we’ve seen over the last 18 months, but I do think we’ll continue to see rent growth until supply and demand come more in equilibrium. I would add that markets where it’s easier to develop will be the markets that probably end up with an oversupply and hyper-supply, whereas the markets where it’s a little harder to develop, like California or Colorado probably won’t overshoot as much over the last 18 months, but I do think we’ll continue to see rent growth until supply and demand come more in equilibrium. I would add that markets where it’s easier to develop will be the markets that probably end up with an oversupply and hyper-supply, whereas the markets where it’s a little harder to develop, like California or Colorado probably won’t overshoot as much.
Office is an interesting asset class right now. In the primary markets, hybrid work is not going to affect square footage that much because you still need space for employees to collaborate. Where it gets impacted is remote work and the gig economy. Google is a good bellwether because they announced that they anticipate being permanently hybrid — three days in, two days flex, with 10% to 20% remote. The 10% to 20% remote will have a lasting impact on office.
Offices in outpost markets aren’t as affected, as they tend to be lower density and more suburban, less reliant on heavy public transit or commute times, and relatively low real estate cost. Consequently, we’ve found that businesses already in our markets are returning to work to a higher degree than in the primary markets. In addition, many people who move into these markets get an independent office, either a small office or co-working space. Then you have businesses that are opening up satellite offices. To use the California Central Valley market as an example, we never saw negative rent growth in the office sector. The lowest we got was zero in Q4 of 2020, and we have seen positive rent growth since then. That should be a huge indicator of these markets.
This is a good mental picture to think about primary versus secondary markets and how they’ve been affected: San Francisco Bay Area, New York and Los Angeles have a fire of economic activity that is white hot. You cannot replace the nexus of business and opportunities in those areas. What has happened is the embers have spread across the United States, and smaller embers have landed in other places. The way to think of it is not that the fire’s gone out; the primary markets will continue to thrive, but high quality of life secondary and tertiary markets will continue to draw untethered knowledge workers.
What are the key challenges?
I’d say where we’ve been a little more cautious is the single-tenant office building. We have found multi-tenant offices to be the winner versus large floor tenants. If you’re vertically integrating, you have property management, and it’s not hard to manage a multi-tenant office building. But we’re moving toward flexibility, and having a very flexible office building is very good.
Using the Jim Collins analogy, we like to fire off bullets and test the market and make sure we understand it and know it well, and then go big. It requires a long period of time to really get to know and understand a market. Getting to that comfort level in secondary and tertiary markets is a very slow-moving process. And you really can’t accelerate it, unless you work with sophisticated operators that already are based there.
Where is capital going to come from?
It’s private high net worth, and that market is very liquid and robust. I would say it’s more robust than the primary markets. Because of the GFC when institutional capital bought large assets and got burned, it’s going to take a little bit of relearning for them. The reality is that secondary and tertiary markets are highly liquid if you’re operating in the right asset size and you’re not reliant on the institutional exit.
What do you think things are going to look like in around 10 years’ time?
Will there be more institutional players with smaller deal sizes? We’re seeing it already, the institutional focus on real estate operating companies that are vertically integrated. I believe you can’t access a niche market without vertical integration. Because of the size of these markets, I think we’re going to look back like we did on multifamily and we’re going to say, “This is a huge market.” It’s learning how to do it. And the way it’ll happen is investors and allocators investing with vertically integrated operators. Ultimately, secondary and tertiary markets will become institutionalized just as self-storage and other niche assets have. It’s too big of a market not to.