Primary, Secondary Markets… Definitions as Clear as Mud

Originally published in CBRE Capital Watch: https://cbrecapitalwatch.com/?p=1655

For an industry as sophisticated as commercial real estate, it is surprising that there’s little there’s little agreement of what is a primary market, let alone secondary or tertiary.

Well, we all agree that the broadly-recognized “gateway” markets (New York, Los Angeles, San Francisco, Chicago, Boston and Washington, D.C.) are primary markets. Fine and dandy. But the water gets far muddier beyond this.

In the U.S. there are 54 metropolitan areas with at least one million population and which are all targets for investment. Are these all “secondary” markets except the six “gateway” markets?

When a highly sophisticated investor indicates that they are focused on “primary” markets, which are they referring to? When a REIT announces their target acquisition markets as the “core” markets, what does that mean? When an industry publication discusses trends in secondary markets, which metros are they referring to? When one of our new cross-border investors indicates a strategy of focusing on “major” markets, is that the same as primary, and which metros would be on their target list? When a CMBS analyst suggests that defaults are higher in tertiary markets, which are they referring to? And when an industry leader refers to “fly over” markets are they referring to non-coastal markets in all property types? It is a puzzlement!

To be fair, there does not have to be one set of parameters that everyone adheres to. And many industry players may not wish to reveal exactly what their target list is, so the ambiguity of “major” markets may suit them just fine.

But for the rest of us who are interpreting market and investment behavior, advising clients, and providing intellectual leadership for the industry, we should be able to articulate more fully how and why we are divvying up the U.S. metros into categories. We all can do better than succumbing to broad generalizations and ambiguous terms.

Tier Methodology

CBRE Research has developed a methodology for determining how to group metro markets and then use these groupings and metro hierarchies for further analysis of industry trends and behavior. While undoubtedly imperfect and still evolving, we offer this methodology and approach to thinking about markets to others in the industry.

We created the methodology originally for the purpose of better understanding investment pricing trends from the cap rate data collected for CBRE’s semi-annual cap rate survey, our most widely read report by far. (Stay tuned, the H2 2015 Survey is coming out soon.)

The model’s fundamental goal was to rank the U.S. metros and then divide them into three tiers. We used the term tier, due to the ambiguity and overuse of primary, secondary and tertiary. We also chose to avoid the more standard terms, because no metro wants to be considered “tertiary,” which has led to the overuse of “secondary.” However, the model’s Tier I markets are analogous to primary, Tier II to secondary and Tier III to tertiary.

Four principal variables formed the statistical basis of the tier ranking model: historical property investment, size of the real estate market (inventory), population size and economic size. The metros were ranked by each variable, and different weights were applied to compute a combined weighted average rank. The largest weights, by far, were given to investment total volume and market inventory.

We did not directly incorporate measures of commercial real estate pricing, investor sentiment or asset value creation. However, these qualities are in the model from the sense that we use the dollar value of investment which is governed by all of three. Also, one of the model’s underlying premises is that, to a large degree, the metro’s tier will drive (or at least explain) pricing and investor sentiment.

Tier I, II and III markets differ by property sector, and a key feature of the methodology is that each sector has its own model. While differential tiering by property type may not seem obvious at first, when one considers, for example, Las Vegas’s role in the hotel industry or Indianapolis’s role in logistics, the necessity of separate tiering becomes obvious. That said, the resulting tier groupings across property types were more similar than different.

With the metros ranked for each property type, the next stage was to determine how broad or narrow the tier groupings should be. After much analysis of the metros (character similarities and dissimilarities), a target split of 20/20/60 made the most sense (20% of metros for Tier I, 20% for Tier II and 60% in Tier III). However, the methodology does not dictate strict adherence to this split due to the close similarity of some markets positioned close to the borders of tier groupings.

With respect to Tier I markets, the model clearly embraces a wider view of markets which should be considered primary than the often used “gateway.” To be sure those “gateway” markets ended up among the Tier I markets in nearly all cases. But other very large and very dynamic markets such as Dallas/Fort Worth, Houston, Atlanta, South Florida and Seattle sometimes or always made it to the Tier I grouping. (The tier methodology could go further and establish a “Super Tier I” category, analogous to Class AA office space, which would serve certain purposes. But for general analysis, Tier I markets should be more inclusive.)

Space is not available to show all the tier groupings, but the office example is presented here as an example. All metros not shown are Tier III. The full tier groups are reflected in the soon-to-be released H2 2015 CBRE North American Cap Rate Survey.

Market Revelations from the Tier Analysis

The research into market tiers goes far beyond just the exercise of grouping metros based on measurable criteria. Its purpose is first to identify behavior by different types of metros, such as cap rate compression between primary and secondary markets. Our quarterly cap rate survey has a wealth of current and historical pricing perspectives based on market tiers.

Second, the tier analysis is used to recognize superior or inferior performance of metros based on their tiers. For example, Austin cap rates have consistently been at levels generally only seen in Tier I and Tier II markets, rather than in line with other Tier III markets.

Another derivative of the analysis is to identify movement of metros within the hierarchy; in other words to answer the frequently asked investor question of, “which markets should I be keeping my eyes on for opportunity or risk?” Our most recent tier analysis, held in conjunction with the cap rate survey, led to a variety of observations on markets and their movement up and down the metro hierarchies from which the tiers are based.

The most interesting observations are represented by a handful of U.S. metros that are on the border of Tier II and Tier III. Portland, Oregon is one of these. Portland used to be solidly in Tier III in all property sectors based on our criteria, but has been edging up in our market hierarchies. We recently officially moved Portland to Tier II in one sector and are watching it closely for possible future changes. Austin and Orlando represent very similar stories. Charlotte is not far behind. Another example is Phoenix, often the highest ranked market within Tier II groupings and representing another dynamic metro which should be on most investors’ radar screens for potential investment.

Industry players do not all need to be on the same page in defining market hierarchies and identifying the members of primary, secondary and tertiary market classifications. Yet, our wish is for greater clarity  in order to improve our understanding of market and investment behavior and to better predict the future.