Strong fundamentals in U.S. second tier cities

The China Investor, Volume 1, Issue 2

Article By Mark Drumm
With strong economic, infrastructure and cost fundamentals, real estate markets in second tier in the U.S. could provide foreign capital with good investment options.

By Mark Drumm

Over $66 billion in foreign capital was invested in the United States commercial real estate markets in 2016, according to Cushman Wakefield. Of this, the largest amount was invested by Chinese buyers who represented 29 percent of total capital invested, which was up 10 percent from 2015. Over 70 percent of this Chinese capital went to four of the major gateway cities, with New York City receiving the largest chunk at 46 percent. In addition, foreign buyers invested an additional $153 billion in residential real estate in the United States of which almost $32 billion was represented by Chinese buyers, according to the National Association of Realtors. This represents a total of almost $220 billion invested in one year in U.S. real estate.  


While much of this capital migrates to the coastal gateway cities, second tier cities in the U.S. provide excellent opportunities for foreign capital investment supported by strong underlying economic growth, solid real estate market fundamentals and far less capital competition. Discussion domestically in the United States regarding economic growth rates or the best markets for investment usually ignites long standing turf wars, but many of these three areas identified above can tell a compelling story of why second tier markets, often overlooked by foreign investors, might provide investment opportunities which better diversify their portfolios, mitigate some risks and ultimately may provide higher returns.  

Investment in second tier markets doesn’t preclude further investment in the gateway cities, but that overall, it appears an ever increasing amount of foreign and domestic capital is chasing too few opportunities in these gateway markets which has the potential to create specific risks for investment concentration, pricing bubbles and overbuilding through new construction all married with low returns. Diversification across more markets outside gateway cities may help mitigate many of these potential risks for all investors.  


Many foreign investors focus primarily on gateways cites including New York City, San Francisco, California, Los Angeles, California, Boston, Massachusetts, Washington D.C. and Chicago, Illinois. For various geographic proximity, historical patterns and exposure reasons, specific foreign investment groups dominate certain of these gateway markets. For example, Asian investors have historically focused on the West Coast with San Francisco and Los Angeles as favorite areas of investment interest. As one of the leading capitals of global finance, New York City attracts the broadest range of foreign investors. While not a gateway city in the strictest sense, Miami, Florida serves as gateway city for foreign capital among Latin American investors.  

Growth expectations for these top investment markets remains strong according to Moody Analytics as places like Los Angeles, California and New York City, New York continue to remain top employment centers in the United States. Los Angeles alone is forecast to produce over 1.4 million new jobs over the next several decades while New York City adds an additional 1.2 million over the same period. San Francisco, California, and its sister cities of Oakland and San Jose, continue to dominate regional growth as Northern California continues to expand as the concentration of technology companies working with big data, autonomous vehicles, artificial intelligence and other disruptive technologies all migrate from science fiction to reality. Boston, Massachusetts also continues to grow with a high concentration of technology and pharmaceutical companies working in cutting edge biomedical fields.  

However, even some of the gateway cities pose some basic market and economic risk. More cautious investors might shy away from markets around Washington D.C. and Chicago, Illinois. As more pressure is placed on the national government budget and it becomes more necessary to bureaucratic cut waste and discretionary spending, the greater Washington D.C. area could experience a significant fall off in growth from the highs of the most recent past and while public pension underfunding issues are pervasive across the U.S., the severity of the issues in Chicago and the State of Illinois has already resulted in net outmigration of people from the State. This type of population shift not only exacerbates existing and growing demographic burdens from an aging population, but places further constraints on State budget problems and further limits possible solutions. Either of these could limit returns on existing or proposed real estate investments in these two gateway markets.  


However, many metropolitan areas throughout the United States provide strong economic growth prospects. Some better than many gateway cities. Dallas-Fort Worth, Texas, for example, has been and remains one of the fastest growing metropolitan areas in the country. It ranks second only to Los Angeles in expected employment growth over the next several decades with forecasted employment growth of over 1.3 million net new jobs according to Moody’s Analytics.  

Dallas’s diversified economy attracts a broad range of relocating corporate and regional employers attracted to its central location, affordable cost of doing business and an attractive low cost of living. According to Sperling’s Best Places, Los Angeles’s cost of living index is at 166 compared to Dallas-Fort Worth’s at 95 (U.S. = 100) means Los Angeles is almost 75 percent more expensive place to live. New York City at 180 is almost 90 percent more expensive. Houston, Texas with its recognition as not just a hub of oil and gas service providers and producers, is now looked at as a global energy hub. Like Dallas-Fort Worth, its low cost of doing business and low cost of living index of 102 should continue to drive more diversified long-term growth. Other second tier cities compare well against the major gateway markets: Miami, 122; Atlanta, 101; Phoenix, 99; Orlando, 96; San Francisco, 272; Boston, 169; Washington D. C. 158; Chicago, 110.

Dallas, Houston, Atlanta, Phoenix and Orlando all represent major international airports, growing world-class health care facilities and good secondary educational institutions. Meanwhile, places like San Francisco with its ever-rising housing costs makes it difficult for young workers attracted to growing area technology companies. This drives workers and growth to other second tier technology markets like Austin, Texas; Portland, Oregon or Seattle, Washington. Ground up development and repositioning of undervalued assets in many of these markets should remain as attractive prospects for foreign investment capital in real estate. While Latin American investors gravitate to Miami with its long historical immigration patterns, cross-border business relationships and Hispanic centric culture, concerns for residential overbuilding persist as construction remains high. However, opportunities for diversification away from Miami exist throughout the State of Florida not just in Orlando, but other areas of southeast Florida north of Miami from Ft. Lauderdale to West Palm Beach and west of Orlando to Tampa.  

While underlying economic growth and good market fundamentals supports a serious look at many markets across the United States, capital flow concentration creates another level of investment risk for many foreign investors. As global capital flows into the U.S. have increased, pricing of existing assets in the major gateway markets have increased with CAP rates falling to unprecedented levels.  

With strong economic, infrastructure and cost fundamentals, real estate markets in second tier in the U.S. could provide foreign capital with good investment options. With less familiarity with these markets it is increasingly important to conduct thorough market research, to determine historic and emerging urban growth patterns and to vet local or regional partners. Following an existing investment partner from a gateway market into one of these newer second tier cities might be a best first option for some.  

(Editor’s Note: May vary slightly as published.)

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About the Author
Mark Drumm
Mark Drumm

<p>Mark Drumm leads Regent Park Advisors and provides focused industry, business and product planning for real estate providers and investors globally. By evaluating a range of factors, such as the competitive environment, socio economic and demographic differentiation, the capital environment, the individual and collective goals, Regent Park develops areas of potential differentiation along with the client to establish an investment or development strategy or mandate to meet the client’s internal goals married with specific market situations. This specialized approach allows for a better "fit" across the investment horizon between investor, producer, geography and the capital environment. Drumm has held numerous executive level positions throughout the real estate business over the past 30 years on development, strategy and investment management. </p>