Monday, June 7, 2010

Tale of Two Cities

Posted by: Scott Beggs
Investment Specialist
775 336 4644

Scott joined NAI Alliance in March 2008 to assist the company with investment sales. Previously, Beggs spent over seven years with Dermody Properties as Vice President of Acquisitions and Port Management.

A “Tale of Two Cities” is Charles Dickens’ famous novel set during the French Revolution. “A Tale of Two Cites” might be a better title for the story of today’s commercial real estate market, where the pricing between “first-tier cites” and “secondary markets” is dramatic.

Commercial real estate assets located in primary gateway cities such as Los Angeles, San Francisco, Washington DC, and New York are attracting significant interest from a variety of well-healed investors including sovereign wealth funds, REITs and pension funds. Multiple bids are being received for high-quality assets in these select markets. However, interest in secondary and tertiary markets is limited at best. The prices offered for assets in the secondary markets are reflective of this limited interest.

This dichotomy in pricing is the result of a flight to quality. In the face of uncertainty about the viability of economic recovery in the United States, investors are trying to avoid all forms of perceived risk. Due to the lack of tenant depth, secondary markets are exposed to significantly higher levels of risk relative to their first-tier cousins. As such, investors are more comfortable paying higher prices (lower cap rates) for projects in cites that are perceived to be relatively immune from recession. Conversely, investors are demanding much higher returns (cap rates) to compensate them for the perceived risk of smaller markets.

Is a risk premium warranted for assets in these smaller markets? Absolutely! However, the appropriate size of the required risk premium is open to debate. The difference in opinion amongst buyers and sellers in the Reno, Nevada market has led to a significant decline in transaction volume over the last 18 months. Buyers expect significant return premiums, whereas sellers expect pricing more in line with major markets.

Which group is correct will vary transaction to transaction. Sellers that have pressure points will be forced to accept the realty offered by cautious buyers. On the other hand, buyers in need of placing capital may move closer to the seller’s asking price, as long as the risks of the project are limited. As an investment sales broker in Reno, Nevada this difference in pricing is important to understand. The NAI Alliance Investment Team tracks all sales and listings in order to better understand this difference and appropriately advise our clients.

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