As traditional mainstream US cities reach saturation point investors in US real estate are focusing more and on cities outside the top tier. "The level of interest has increased in the last six to 12 months as yield and cap rates have declined," notes William Maher, director of North American strategy at Jones Lang Lasalle.

But this increased interest has by no means been a landslide. "The trend has been a little over-reported," says Dan Fasulo of Real Capital Analytics, which has measured foreign investment in secondary markets for IPE Real Estate. "Some investors are being a little more adventurous to get higher returns, but this has been more a selective asset-by-asset situation, rather than a shift in thinking."

There are almost as many cities in the US as there are in the EU and they can be segmented in a similar fashion, as Youguo Liang, managing director of research for Pramerica Real Estate Investors explains.

In Europe, there are ‘global' cities, such as London and Paris, which can be distinguished from ‘national' cities, such as Amsterdam, Brussels or Madrid. All cities beyond these are classed as secondary.

Similarly in the US there are fully global cities: New York, Washington DC-Baltimore, San Francisco, Los Angeles, Chicago and Boston make most lists. And this is a list that is constantly changing, depending on whom you speak to, and when. Some say Chicago has left the top tier, others that Seattle has joined the ranks. Roughly half of all institutional real estate investment opportunities in the country are in these largest cities.

Whatever the exact definition of the top tier, that means that the other institutional opportunities lie beyond this top tier - and this is where foreign investors are looking, as they chase yield in an increasingly crowded market.

Cities outside the top tier in the US can be classed either as ‘major' cities - those with a population of around 5m, such as Dallas, Texas, or Atlanta, Georgia; or as ‘secondary', or opportunistic, cities, such as Salt Lake City, Utah; Tampa, Florida; Charlotte, North Carolina; San Antonio, Texas; or Memphis, Tennessee, those cities that have populations of 3-5m people.

"Foreign investors tend to view so-called major cities as secondary investments," says Liang, as they focus on the bigger and better known cities, "whereas US institutional investors have always been interested in upper-tier secondary cities. Prime examples include Sacramento, California; Portland, Oregon; the Raleigh-Durham area in North Carolina; or Minneapolis-St.Paul in Minnesota."

Foreign investors tend to prefer cities with which they are familiar, through historical business ties or even holiday patterns. For instance, the significant German investment activity in Atlanta is in part due to the fact that Lufthansa flies there direct and many Germans take vacation there, notes Mike Acton, director of research at AEW. This also explains why there is significant foreign investment in Orlando and southern Florida.

In some ways, US secondary cities are similar to national cities in the EU - their demographic and geographic profiles are similar. But as Liang explains: "The US market is more dynamic and experiences stronger employment and population growth." Cities experiencing strong population growth at the moment include Orlando, Houston, Dallas, Seattle, and San Diego.

"Rent cycles are also much stronger - they may decline dramatically, but they also go up stronger and faster," notes Liang. He pointed out that rents across the US bottomed out in 2004 and now the market is in its second year of rent recovery; he predicts four more years of rental growth going forward.

Some investment advisers take a broader view of what is primary than others. Pramerica Real Estate Investors includes Miami, Atlanta, Dallas, Seattle and Houston on its list of US primary markets, according to Dale Taysom, managing director, acquisitions. "Europeans are most comfortable in major cities, but our investors are active in Denver, Atlanta and Seattle," he notes.

Taysom justified Pramerica's broader definition when he pointed out that the major job growth over the last decade in the US has taken place in such cities as Atlanta and Miami. Other cities to have experienced strong population growth include Orlando, Houston, Dallas, Seattle and San Diego. With this growth comes increased need for housing and commercial development, which is why these cities can represent good opportunities.

It is true that in the US, cities can show a degree of population growth and economic development that is unmatched by European cities. Liang pointed out that "Dallas will be a top city in 20 to 30 years. This kind of dynamism is not typical for European cities."

"It is essential to have a critical industry mix, creating value in economic activity," explains Acton. In Manhattan, for example, high value-added activites have crowded out the low value-added activities. The employment mix is biased toward high wages and therefore people can pay high dollars for the use of space. "In the mid-tier market, this is largely not the case."

There are some exceptions - Boise, Idaho is one example that Acton notes, a city that is currently thriving because of a newly growing high-tech industry base (and one where, incidentally, development potential is limited by mountains) - "but there are very few such markets."

Because cycles are so dramatic, markets change quickly - this means that sometimes investment in secondary markets makes a lot of sense, other times less so. Whether or not an individual city represents long-term value is often a complex judgment, making investment in secondary cities a riskier prospect.

"Those markets don't have the density you need for value long term," says Acton. "Manhattan makes sense - with a population of 8m, there is a density of people that ensures that there is always a demand for residential at least." There's a point here - Manhattan has seen a great deal of conversion of office and hotel properties to residential in recent years.


There are several potential dangers involved in investment in secondary markets. One is that liquidity is definitely limited, as these markets tend not to be as trading oriented as major cities are. "Your exit strategies are limited," warns Acton. "You can overpay in New York City, but chances are that someone will want to buy it from you."

They are also more volatile. One event - a plant closure, for example - can dramatically change the profile of a smaller city.

This volatility means that timing is everything, notes Taysom. "If you miss the cycle in Los Angeles, it comes back around quickly. In Birmingham, Alabama, it may be a long time." He also points out that "fundamentals deteriorate more rapidly in those markets" as interest rates change.

Additionally, there are few barriers to new supply in many US secondary and particularly in tertiary markets. These newer cities often do not have traditional ‘downtowns' and instead sprawl over broad areas. "When you get into a city like Nashville, Tennessee, the markets have not gone vertical and there are no physical boundaries to further development so there is no protection on the supply side," explains Acton.

Secondary city investments are always very sector-specific, but there is difference of opinion as to which sectors are advisable. For example, Taysom says that "for us to go to secondary markets, it's generally retail and housing. People shop everywhere and have to be housed everywhere." In addition he cited in-house research that found, after an analysis of more than 500 transactions that both the office and industrial sectors in secondary markets were significantly more volatile.

Maher points out that Jones Lang LaSalle favours long-term industrial or retail investments, in part because they are available with 15-year leases, which can mitigate somewhat the increased volatility in those markets. He also stressed the importance of going with good credit. That said, some new industrial developments, particularly in transport and warehousing, are being located in very remote areas (although they may have good transport situations) and Maher says that he would tend to avoid those.

There are more opportunities for investment in the retail and residential sectors, notes Liang of Pramerica. "In the US, the top industrial and office markets are highly concentrated. On the other hand, retail and residential are very widespread, and there is interest in many secondary cities."

There is quite a lot of good quality information available covering all markets, both primary and secondary. As around 90% of real estate is privately held, the market is rather transparent, especially in comparison with Europe. The REIT market has also successfully pushed for more transparency.

Nonetheless, as Acton stresses, "you need a good, strong partner to guide you through these markets. There is not a lot of activity and there are a lot of issues".

In addition, the US has its own peculiarities. For example, there are many state-by-state differences in legal systems, taxation and even union rules that come into play. Taysom agrees with the need for on-the-ground expertise. "I would be a little nervous about going in without a local partner," he says.

In the past there was a significant premium for investing in secondary markets. However, in the current market, pricing and yields are tight across the board and it is not clear whether the benefits of secondary cities outweigh the potential risks.

Foreign investors also have to make judgements about investing in US real estate itself, even before they look at individual markets. At the moment, concerns about the state of the dollar and the US trade deficit have caused a decline in European investment across the board; many foreign investors are looking elsewhere, for example, to Asia for international diversification and to their own European secondary markets for sector diversification. Views of the US property markets in general have calmed down, as investors become increasingly concerned with pricing - and the difference in returns between the EU and the US has narrowed.

Data from Real Capital Analytics, produced for IPE Real Estate, shows that foreign investment in US real estate slowed across the board in 2006. Tellingly, investment in primary markets has held up much better than investment in secondary markets has. Investors are staying with the surer bet as the outlook becomes less rosy than it was even 12 months ago.

Even for those European investors who are committed to a US real estate investment programme, not all advisers recommend secondary cities to their clients. ING Clarion Partners is a case in point. "We do not see enough pricing differential to justify investment in most secondary markets," says managing director, Bill Krauch. "It remains to be seen whether investors are properly rewarded, given the drawbacks."

"We keep debating whether the yield premium is enough," says Maher. "It varies between 25 and 75bps - at 75bp it makes a lot of sense, at 25bp we scratch our heads." But he also pointed out that as long as pricing continues to go up in major markets, investment in secondary markets will be popular. Pramerica agrees: "We have not seen enough a spread to go to those markets," he says, outside their broader than average list of primary cities.

And as to ‘tertiary' cities - for the time being, there is a resounding no. "Most institutional investors shouldn't be doing that," says Maher. "These are one-horse towns. It might be okay for a US institutional investor with a very big portfolio, but if it is going to have any meaningful impact on the portfolio, investors should not be doing that."