The Advantages of Middle Market Commercial Real Estate
Everyone likes a trophy, and glamorous properties in big cities have certainly benefited from the recent strong real estate market. But much less attention has been paid to the resurgence of “middle market” commercial properties. We’ll explore here the opportunities offered by smaller-value transactions in areas not considered “gateway” markets.
Less a Trophy, More a Workhorse
The perception that some real estate markets may be over-valued has been driven, in part, by the appreciation of trophy assets in gateways cities like New York, Boston, Chicago, and San Francisco. These are the cities to which institutional and foreign investors often turn when real estate comes out of a recession. As a consequence, the “upside” in these markets can increasingly dry up as a business cycle elongates.
In such a late-cycle market, investors often seek properties in secondary markets that offer higher yields and better values. Under the right circumstances, these comparatively under-appreciated cities—Denver, Phoenix, and Dallas are good examples—can potentially offer investors an attractive opportunity. Global investors don’t seem to chase the small-balance market, for one thing. Another differentiator is that the middle market commercial market tends to move more in tandem with the residential housing space, which has also ticked up as of late. Notably, many of these second-tier cities also boast strong job growth.
Of course, it’s all well and good to tell a story about elongated cycles and undervalued markets—but do the data bear it out? The answer seems to be yes. The below graph, utilizing data obtained from Real Capital Analytics (RCA), illustrates the potential middle-market advantage by showing average capitalization rates in major versus non-major metro areas. (A cap rate is the ratio of a property’s net operating income to its current market value, with higher cap rates often considered – all other things being equal — relatively more advantageous for buyers and investors.)
Capitalization Rates in Major Metropolitan Areas vs. Non-Major Metropolitan Areas
Source: RCA. Includes multifamily, office, industrial, retail and hospitality transactions with individual transaction sizes of less than $50 million during the trailing 12 months (as of June 30, 2017). Major metro areas include Boston, Chicago, Los Angeles, New York, San Francisco, and Washington, D.C.
As one can see, properties in non-major metro areas have historically been financed at higher capitalization rates, likely indicating that capital has been less available in those non-major markets. This differential is sometimes attributed to the perceived difficulties faced by larger institutional investors in dealing with investments of less than $10 million. Assuming it costs those financiers about the same amount to process and underwrite a particular transaction, their time would naturally be spent on the larger opportunities where the absolute returns are accordingly higher as well.
The same principle holds when a single non-major metro (Dallas) is compared with a major one (Los Angeles). The first graph below shows a positive cap rate differential regardless of the gross asset value (GAV) of an underlying property. The second and third graphs suggest that even within a single market, capital availability remains dependent on transaction size.
Historical Cap Rate Differential Between Dallas and Los Angeles
Historical Cap Rate Differential for Los Angeles By Transaction Size
Historical Cap Rate Differential for Dallas-Ft. Worth By Transaction Size
This financing gap is especially significant since RealtyShares’ review of transaction data available from RCA showed that transactions involving properties worth $50 million or less represented over 90% of the transaction volume during the periods shown. Thus, larger yields seem to be available simply because of capital inefficiencies in those markets.
Other Potential Benefits of the Middle Market Sector
In addition to the apparent reduced financing competition in the middle market sector, there are other potential benefits of this space. “The prices in the small-cap CRE (commercial real estate) domain don’t have the same peaks and valleys as the large CRE market,” said Randy Fuchs, principal at Boxwood Means, a research group that surveys trends in smaller commercial properties. In addition, some of the market’s attractiveness can be ascribed to a continued relatively lack of new construction projects. The pace of construction in Q2 2015 was at just 40 percent of the long-term quarterly average rate, and even today construction financing seems to remain difficult to find for middle market properties. “It is a bit of a head-scratcher that developers of smaller buildings have not responded to the very tight vacancies that exist in the small-cap domain,” Fuchs said. Developers seem to be more focused on higher-end properties where there is a better prospect of recouping the related construction costs.
Finally, because rents in gateway markets have become so expensive, at least some tenants seem to be moving to the suburbs. The below chart shows that there have been rapidly declining vacancy rates in suburban commercial properties, and we’ve seen no evidence that this trend has changed in more recent periods.
Stay in the Middle
In RealtyShares’ experience, the cost of debt financing for middle market transactions is usually only a little higher than for larger property transactions, the higher cap rates for middle market properties can create positive leverage advantages in that sector. Middle market opportunities can thus potentially provide for greater common equity and cash flow “cushions” relative to a property’s purchase price and current potential yield. This possible advantage is of particular benefit to middle market projects involving value-add strategies, where renovation efforts cause much of the expected upside to be derived from a property’s appreciation potential and not current cash flows.