Secondary markets may look enticing to investors in core commercial real estate, as investors seek out higher yields. Over the long term, however, primary markets have provided stronger and more consistent returns.
At first glance, commercial real estate in secondary markets in the U.S. may look attractive compared to other core real estate.
Relative to lower capitalization rate cities such as Boston, New York and San Francisco, these markets can offer higher yields and, if current volatility is any indication, little added risk. Yet, today's risk-reward dynamics belie historical trends—and likely aren't sustainable. When it comes to office space in particular, core real estate investors should continue to heed the mantra "location, location, location."
In a new report, the Morgan Stanley Real Estate Investing Research team analyzed the track records of institutional properties to identify three characteristics of markets most likely to generate strong and consistent returns over time: strong liquidity, high absorption rates, and constrained supply. Core investors need to consider these fundamentals and how they ultimately drive long-term, consistent value and returns.
This is why strong liquidity, high long-term absorption rates, and barriers to supply are fundamental to investing in core commercial real estate. While the performance of apartment and retail assets depends largely on the specifics of the property, total returns for office space are closely tied to the city in which they're located.
Liquidity, the availability and ease of capital flow, can vary widely. Among the 50 largest U.S. office markets, a dozen (Austin, Texas, Charlotte and Raleigh, North Carolina, among them) saw a significant drop in liquidity at different points in the business cycle, even if liquidity was at times strong, according to Morgan Stanley Investment Management research.
After factoring for liquidity and depth, just 15 markets remained. The final hurdle—supply as measured by consistently low vacancy rates—whittled the list down to just five cities: Boston, New York, San Francisco, Seattle and Washington D.C.