Investors are returning to smaller cities such as Provo, Utah and Clarksville, Ind. in search of fresh opportunities and higher yields. And they are pulling lenders along with them.
Debt and equity financing available for deals in tertiary markets is far from free flowing. Yet there is a growing pool of lenders willing to do those deals.
“The market is opening up. It is not as open as financing in the core markets, but it is better than it was three years ago,” says Andrew Kirsh, co-managing partner and head of the real estate practice for Sklar Kirsh LLP, a Los-Angeles-based law firm. “There are a lot of options for a borrower and an operator.”
Capital sources pulled back from tertiary markets in the wake of the economic downturn. There was a good deal of concern in the lending community that the economy would not bounce back nearly as quickly in the markets that didn’t have a broad employment base and foreseeable growth. So lenders were essentially “redlining” the smaller areas, notes Jeff Hudson, CEO of George Elkins Mortgage Banking Co. in Los Angeles. “A number of lenders even said: ‘don’t bring us anything with an MSA less than 50,000 or 100,000 people,’” he adds.
Now many lenders are reversing those decisions as the economy improves and they are facing more competition in primary and secondary markets and a desire to capture higher yields. That is not to say that lenders are as eager to finance a property in Athens, Ga. as they are to finance a property in Newport Beach, Calif.
“They will look at their underwriting under different parameters and evaluate the trends with more depth. But at the end of the day, they will make loans,” says Hudson.
George Elkins has recently arranged financing on transactions in Clarksville, Ind.; Rapid City, S.D.; and Prescott, Ariz.
Lenders across the board, including banks, life companies, government agencies, CMBS and non-conventional lenders and funds, are all dipping their toes back into tertiary markets—at least to some degree. That being said, drill down into those different groups and the list of who is actually active in tertiary markets remains very selective. Some lenders are pulled into tertiary markets solely by relationships with existing borrowers. In the case of banks, for example, lending in tertiary markets is largely dominated by local and regional operators versus the nationals.
The majority of lenders have seen budgets increase in 2014, meaning they have more capital to place. CMBS lenders in particular seem to have an insatiable appetite to do new deals, largely because there is a more robust market of B piece buyers, notes Hudson. George Elkins recently helped to arrange $7 million in CMBS financing for a retail project in Tupelo, Miss. that includes tenants such as TJ Maxx, Hobby Lobby and Office Max. Most CMBS lenders won’t go into extremely small markets, but they are becoming more aggressive and are willing to do deals in markets upwards of 50,000 people if there are strong credit tenants and a good predictability of cash flow, he says.
However, tertiary markets remain more challenging than primary or secondary cities. Lender options are limited and financing rates are higher compared to deals in core markets. Leverage in these tertiary markets is often more conservative than leverage in the core markets. Deals also are getting more scrutiny as lenders look to get comfortable with the risks they are taking.
Karlin Real Estate is going where the opportunities are and it just so happens that some of those opportunities are surfacing in smaller cities such as Jackson, Wyo. and Crown Point, Ind. “We recognize inherently that there is more risk in these secondary and tertiary markets where you may have less macro demand,” says Larry Grantham, a managing director at Karlin Real Estate in Los Angeles. But at this point in the cycle, Karlin is willing to trade the risk for the higher returns that the secondary and tertiary cities offer in an improving economy.
Karlin has invested over $1 billion in the past few years in both equity and debt, providing senior and mezzanine bridge debt to borrowers who are buying transitional assets.
“It is so competitive in these primary markets that investors like us and others are struggling with whether or not we are getting paid appropriately for the risk we are taking,” says Grantham. “That’s where you start to get a little more comfortable in some of these secondary and tertiary markets.”
This article was republished with permission from National Real Estate Investor.