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Opportunities for commercial real estate (CRE) owners and operators are flourishing outside of the largest U.S. metropolitan markets, such as New York and San Francisco. Investors exploring Memphis, Phoenix or Salt Lake City, among other cities in the Tier 2 real estate market, can earn strong returns by developing or purchasing and repositioning older properties.
Activity in Tier 2 cities has surged in recent years, driven by the general affordability and relative price stability, as well as the lower levels of competition for properties. These attributes are drawing investors away from the biggest cities, referred to as Tier 1 markets. Investors looking to purchase commercial real estate can benefit by participating in the economic growth of these regional centers, as shown in their generally favorable numbers for employment, tax policy and college graduates.
Throughout my more than two decades in real estate lending and investing I’ve followed Tier 2 cities closely and recognized the opportunities they present for owners of commercial real estate and lenders, and our nonbank lending business has invested heavily in building a loan originations team with deep, region-specific expertise across the nation.
Prices Higher, Yet Stable
While real estate in general has seen roughly a decade-long appreciation in values, CRE has risen in a more measured way. Despite price increases, Tier 2 commercial markets have remained attractive to companies because their home values and overall living costs are more affordable, as compared to those in Tier 1 markets.
For many developers and investors looking to purchase commercial real estate, Tier 1 prices remain out of reach. Consequently, investors can bet that Tier 2 market properties represent a safer play at this stage of the real estate cycle.
Generally speaking, there are more opportunities in Tier 2 markets because of favorable economic conditions and fewer deep-pocketed hedge fund and private equity investors competing for these properties. The largest investors looking to acquire real estate seek Tier 1 properties that typically start at $50 million. Tier 2 properties are more often valued between $5 million and $25 million. Fewer competitors and a lower starting base allow investors to reap higher returns in Tier 2 markets.
Looking For The Signs
Investors in Tier 2 cities assess local drivers that illuminate the general health of the job market and employment rates, as well as economic factors particular to the region. By comparison, Tier 1 markets are global cities; larger economic and even political forces can affect their valuations.
For example, Salt Lake City offers an educated workforce through a wealth of post-secondary educational options and lower-cost housing. Investors have noticed how Utah’s capital is developing into a technology hub with high-tech firms dotting its suburbs.
Other cities have drawn interest by doubling down on their strengths. Memphis specializes in shipping and logistics and boasts the second-largest cargo airport in the world. FedEx is investing more than $1 billion locally. My firm has recently closed deals on two low-rise, multifamily apartment buildings in Memphis totaling $9.7 million.
When companies relocate or open branch operations in Tier 2 cities, the wider markets often benefit from the multiplier effects that their workforces generate. Ancillary businesses that emerge to support the new employer themselves bring new workers. For example, restaurants, stores and schools open or expand to support the arriving workforces’ families, triggering a ripple effect of economic growth.
Commercial real estate owners and operators will continue to be drawn to Tier 2 cities that post healthy economic numbers and offer accessible entry points with less potential for dramatic downside swings.
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