As core apartment markets heated up over the past several years, many investors looked to place capital in secondary and tertiary markets where cap rates were more advantageous. Denver, Dallas, Austin and Phoenix, among others, were viewed as opportunistic markets as companies entered or expanded there, subsequently creating a greater demand for rental options from a growing workforce. Value-add, garden-style apartment communities in and around these high-growth markets could be found at a significant discount compared to gateway cities such as Los Angeles, San Francisco, New York and Chicago, creating higher returns for investors.
Over recent months, however, I have seen investors beginning to recalibrate, returning to core markets to place their capital. Paradigms have shifted as they look at the shrinking value-add inventory in secondary and tertiary markets. That, combined with the fact that cap rates in non-core markets are approaching core-market cap rates in the range of 4.5 percent to 5 percent, confirms that core markets are starting to offer more compelling risk-adjusted returns than their non-core counterparts.
In Los Angeles, for example, tech and creative firms focused on content creation, such as the FAANG (Facebook, Amazon, Apple, Netflix, Google) stocks, have been a catalyst for job growth and rising demand for housing options. Although we all hope for more housing options, we can’t argue with the fact that primary markets will continue to see a lack of supply and heightened demand, with a growing population of highly skilled employees. As new development becomes harder and harder to execute due to rising construction costs, high land prices and increasing regulatory oversight, core markets are poised to experience even more impenetrable barriers to entry for future product.
Ultimately, some of the fundamental ingredients of a core gateway market are high barriers to entry, low incoming supply, a growing skilled labor force and robust foreign capital investment. Gateway markets will likely be an increasingly popular risk-adjusted return profile that investors will seek out as 2020 unfolds. The combination of COVID-19 taking its toll on the overall economy and broader business climate, the likelihood of a recession on the horizon and historically low interest rates provide plenty of reasons for investors to return to the attractive fundamentals of core markets as a hedge against the unknowns over the coming months and years.
BJ Turner is the founder of Dunleer, a real estate investment and development company that specializes in niche-focused, value-add real estate investing in Southern California.