A cliché in real estate investing is that the three most important factors in determining a property's value are "location, location, and location." While one aspect of that meaning is the physical placement of the property and its proximity to things like amenities, downtown, or water, it's also vital that it be in the right market. An apartment building in the heart of a small town won't command the rental rate as one right near the central business district (CBD) of a major gateway city.
Because of that, real estate investors use three different classifications to determine the desirability of a metro market: Primary, secondary, and tertiary. Here's a look at that third term.
What are tertiary markets?
Tertiary markets, also known as Tier III markets, are the third market classification for metro areas behind primary (Tier I) and secondary (Tier II). While there isn't a standard definition, generally, a tertiary market has a population of fewer than 1 million people. For comparison's sake, secondary markets typically have a population between 1 million and 5 million, while primary markets are major gateway cities with more than 5 million people.
However, population alone isn't the only factor. Real estate investors would also define a Tier I city as having an established real estate market and highly developed infrastructure. Because of that, many real estate investors don't consider a major city like Detroit to be Tier I because it lacks the investment activity and desirability of other primary markets. On the other hand, Austin is a smaller metro area by population but has a Tier I market investment activity level. Because of that, many consider it to at least be a secondary market.
Aside from being generally smaller markets, another characteristic that tends to define a tertiary market is its growth prospects. Tier III markets often have a higher population and employment growth rate compared to primary and secondary markets. However, tertiary don't have the highly developed infrastructure and real estate markets of bigger metros, making them a bit riskier. Further, an economic downturn tends to have a greater impact on Tier III markets.
The growing importance of tertiary markets for real estate investors
Large real estate investors have traditionally focused most of their attention on primary markets. For example, the largest office REIT in the country, Boston Properties (NYSE: BPX), only owns properties in Tier I gateway cities (Boston, Los Angeles, New York, San Francisco, and Washington DC). Similarly, large-scale residential REIT Equity Residential (NYSE: EQR) primarily focuses on primary markets (Boston, New York, Washington, Seattle, San Francisco, and Southern California (Los Angeles, Orange County, and San Diego), though it also owns properties in Denver, which is a secondary market.
Because so many investors -- especially deep-pocketed REITs and institutional investors like real estate private equity funds -- focus on primary markets, and to a lesser extent secondary ones, there's a lot of competition for investment properties in those metros. That has driven up property prices and pushed down investment cap rates. As a result, a Class A property in a primary market will typically trade at a lower cap rate than a similar building in a Tier II market. Likewise, real estate in a secondary market will sell at a lower cap rate versus a comparable one in a Tier III market.
Because of that, real estate investors have started focusing more on secondary and even tertiary markets in recent years in search of better deals and higher returns. Smaller Tier III metro areas like Las Vegas, Nashville, Charleston, and Richmond offer many attractive qualities for real estate investors, like above-average population and employment growth. One result of these traits is that rental rates in those metro areas have tended to grow faster than the U.S. average. That can enable real estate investors to earn higher returns, especially since they can buy properties at higher cap rates.
What real estate investors should look for in a tertiary market
When considering tertiary markets, real estate investors should look for metros that boast the following characteristics:
- Above-average population growth.
- Strong employment growth from a diversified employment base.
- Healthy rent growth.
- Well developed infrastructure to support the metro's growth.
- Desirable characteristics such as lower taxes or property values, lots of amenities, good schools, warm weather, etc.
Ideally, what investors would want to see in a tertiary market is the potential of it growing into a secondary market. A good example of this is Austin, which has grown rapidly in recent years into one of the more desirable locations for real estate investors because of consistent above-average population and job growth, which has driven solid rental growth. A city that's earlier on in its growth cycle but with a similar upside profile could make an ideal tertiary market for a real estate investor.
Tertiary markets offer real estate investors more upside
Tertiary markets aren't as large nor as stable as primary and secondary markets, which makes them a bit riskier. However, these metros do offer investors more growth potential as well as higher cap rates. Because of that, they shouldn't overlook these metro areas. Instead, they should look for areas that have potential for moving up the property ladder, since that advancement could lead to earning excellent investment returns.