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Opportunity in Smaller Markets

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Brokers and Agents
Posted: 22 Mar 2013

Commercial investment real estate has made a comeback since the depths of the Great Recession in 2009. But as more and more investors come back into the market, returns are dropping precipitously in the major real estate markets around the country. The primary and gateway markets consisting of large cities such as New York, Washington, DC, Chicago, Boston, Los Angeles, San Francisco, and secondary cities such as Denver, Houston and Atlanta, are starting to see capitalization rates on acquisitions and overall returns again decline to historically low levels not seen since just before the recession started in 2007 and 2008. These low returns are being driven by a combination of historically low interest rates and demand from well capitalized investors looking for good investments.

ItaEU(tm)s unlikely that another recession is just around the corner, but with commercial real estate interest rates hovering around 4.0%, low capitalization rates (net income produced by the property divided by the cost of the property) on investment properties seem attractive. But there is a big risk in buying investment real estate at these low capitalization rates even in this low interest rate environment. The risk is that interest rates are very likely to trend higher in the next few years, pushing up yields and investment real estate capitalization rates. Mortgage interest rates are typically priced off the 10-year U.S. Treasury bond rate. The current 10-year U.S. Treasury bond rate is 2.1% versus the long-term average yield for the 10 year bond of 6.64%. At some point interest rates will return to the average and capitalization rates will increase as well. As capitalization rates increase, the value of an investment property will decline. For example, a 100 basis point (i.e. 1.0%) increase in the market capitalization rate from 6.5% to 7.5% would result in 13.3% decline in a propertyaEU(tm)s value, if all else stays the same.

So where can investors find better returns? As the major markets become more competitive, investors looking for higher returns, and a hedge against rising interest rates, are looking more and more at secondary and tertiary markets such as smaller regional cities and towns. The best of these secondary and tertiary markets are the ones with the strongest growth prospects. About ten years ago reports by the Urban Land Institute and H.S. Dent Publishing, made a strong case that a new demographic trend was about to unfold in which about 20% of the North American population, approximately 70 million people, will migrate from the larger metropolitan areas of the country to exurban areas, small towns and new growth cities in the next three decades due to better communications technology and the search for a better lifestyle. This trend began to unfold in the first half of the last decade, but slowed during the recent recession. A report in the Wall Street Journal last week indicated that this trend is again picking up momentum.

The primary beneficiaries of this migration will be small towns that have unique amenities, such as resort and college towns, emerging new cities whose economies are supported by new technology and medical industries, and exurbs, the cities growing up around some of the key gateway cities. These types of communities are projected to see the most growth over the next twenty-five years, and could offer the best opportunity for real estate investors looking for higher yields with strong upside potential. Some of the Colorado markets mentioned in these studies include places like Denver, Boulder, Colorado Springs, Grand Junction, Steamboat Springs, Summit County, the Vail Valley and the Roaring Fork Valley from Aspen to Glenwood Springs. As the national economy slowly recovers and the major markets get overcrowded with investors, this might be a great time to acquire well located properties in these promising secondary and tertiary markets