The Crucial Role of Submarket Selection

Authored by Britteni Lupe

The recent wave of new apartment deliveries has downshifted fundamentals across most markets. However, supply exposure varies significantly among – and even within – markets, meaning that some areas are feeling the pressure more than others.?

We believe the new real estate cycle will be one where evaluating markets at a more granular level will be the key driver of outperformance. Why? Because sector-level total returns are expected to converge over the next few years (absent office), offering less differentiation than before. As a result, outperformance should hinge less heavily on weighting portfolios toward any single sector but more on driving value through a more granular approach.

In this environment, an ability to peel back the layers on market-level narratives to uncover underappreciated nodes of strong performance is especially helpful.?

One way to do this is by looking at variation in performance between the best and worst submarkets. In Figure 1, we can see that over the past 12 months, the spread of rent and occupancy growth between the best and worst performing submarkets in Tampa is substantial. This suggests that making the right call on which neighborhood to invest in is more impactful in this market than in one like New York, where submarket variation shows a tighter spread. In other words, less variation and a tighter spread means there is less potential for outperformance from submarket selection, whereas a greater spread means there’s more potential upside.

Even in a short span of time, the importance of selecting the right submarket is evident. Over just 12 months, the spread between the nation’s best and worst submarkets has reached a remarkable 218%, meaning the best-performing submarket saw annualized RevPAF growth of 152% versus the worst, where collectively rent and occupancy declined 66%. This shift suggests the start of a new cycle, marking a departure from the five-year trend, where the average spread was 145%.?

With volatility in interest rates – and our prediction of “higher for longer” – income is likely to regain its importance in real estate total returns going forward. This means that an ability to pinpoint localized dynamics that are supportive of rent and occupancy growth is likely to be rewarded.?

At ARA, we monitor performance of 1,400 submarkets using a proprietary method that incorporates long term rent and occupancy trends in order to determine stickiness and momentum simultaneously.

Connect with us if you’d like to learn more.