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NAIOP: Taking a Look at Second-Tier Markets

NAIOP: Taking a Look at Second-Tier Markets

This article was written by Colin Underhill and Matt Willinger and originally appeared in the NAIOP Spring 2024 Issue on March 29, 2024.

Considering up-and-coming secondary markets can be a wise move.

Experienced investors understand the advantages of having a diversified portfolio, and second-tier markets can be part of such a strategy. As the economy continues to waver, large institutional investors can afford to centralize and maintain dominance in stable metros with high migration rates like Dallas, South Florida and Nashville. However, secondary markets such as Louisville, Kentucky; Indianapolis, Indiana; Birmingham, Alabama; Kansas City, Missouri; and Buffalo, New York, have less competition and lower barriers to entry and may benefit from recent federal programs aiming to boost North American manufacturing (see feature box below).

No two markets are created equal, and some of the best places to invest are in cities on the cusp of a boom. By entering these cities now, investors and business leaders can learn the communities, their cultural identities and their economic strengths, and be privy to locals’ needs as the city grows. Those interested in exploring these cities should consider the following strategies.

Evaluating a City’s Growth Potential

Well-positioned real estate maximizes the opportunity for a profitable outcome, and there are several ways to determine a city’s long-term potential.

Industry growth

A key indicator of a city’s growth potential is the health of its job market and the presence of major industries. A diverse job market reflects economic resilience because it is less susceptible to single-sector downturns. A thriving job market also indicates a higher quality of life because it creates opportunities for stable employment and income growth for residents. Subsequently, these residents are more likely to invest in the community and support local businesses and infrastructure development, in turn attracting more businesses and talent to the city. Major industries are also a source of technological advancement and innovation that attract skilled workers and entrepreneurs, further driving economic development. The health care and technology sectors are two key industries to watch. As these sectors continue to migrate from the coasts and find homes in Midwestern and Southern states, the cities where they plant their roots should be noted.

Physical space for growth

Unlike major urban hubs, smaller markets still have physical space for growth. With less space having already been developed across these metro areas and their surrounding suburbs, residents, business leaders and investors can acquire properties at reasonable prices. As neighborhoods continue to grow, property values will increase, and so will the demand for local amenities and housing. Investors with an established presence in these markets will be knowledgeable about community needs and positioned to be leaders in answering demand.

Resident lifestyle

In a post-pandemic world, cost of living is a key factor for industry leaders, entrepreneurs, young talent, skilled laborers, and families looking to plant roots. Beyond that, people are searching for a sense of community, urban amenities and timeless allure, and second-tier cities often have that small-town feel that inspires collaboration and propels business. This environment is a breeding ground for local businesses, startups and grassroots initiatives that are catalysts for economic growth.

Second-tier cities sound like an ideal investment environment, but real estate expeditionists need to be tactful in working with the local market, not against it. Residents of large urban hubs are accustomed to frequent new developments and national chain presence, but smaller-market residents can be turned off by inauthenticity and an avaricious approach. Instead, they typically value culture and an appreciation for the historic charm of their city.

Entering these markets now, while they’re still novel, allows investors to learn the market well and position themselves for the long-term growth these cities will experience.

Strategies for Navigating Second-tier Markets

As is the case with all markets, second-tier cities require market research, due diligence and tailored investment strategies to create well-received, profitable outcomes. But these markets need investors who will celebrate the city’s culture rather than metropolize it.

For example, Louisville’s rich heritage and historic charm have created a surge in tourism, and the city ranks on top ten lists for housing and job growth (see feature box below). It also serves as a gateway to the Kentucky Bourbon Trail, is home to the world’s largest baseball bat and the world-famous Kentucky Derby, and possesses a vibrant arts scene. Developers can leverage both historic and tourism tax credits to create entertainment venues and hospitality services in historic buildings or that integrate cultural experiences.

Furthermore, outside investors must learn about a city’s neighborhoods, diverse populations, industry clusters and population patterns. Simply replicating another market or emulating what locals are already doing could leave gaps.

To keep up with migration and economic factors, Louisville has experienced a surge in multifamily properties. Typically, these properties are developed in a more suburban part of town, and outside investment and development firms may see this as an opportunity to grab a piece of the pie or develop nearby amenities. However, a thoughtful investor will notice that the city’s historic charm is concentrated around its urban core and old neighborhoods. Neighborhoods like NuLu, Butchertown and Germantown have experienced exponential growth in recent years and draw locals and transplants to the city. While there is less space to develop new properties in these neighborhoods, redeveloping and reimagining urban and underperforming spaces can result in more immediate cash flow investments by entering the project with a finite set of outcomes, eliminating the zoning and permitting procedures, and shortening the design process.

Local Partnerships Improve Outcomes

Opportunity abounds in second-tier markets, but for investors, developers and business operators who are not locals themselves, learning these lesser-known markets can be a challenge. Tapping local partners is a strategic approach that can significantly improve the chances of realizing higher-quality, long-term return on investments.

Especially in “everyone knows everyone” cities like Louisville, a local developer or joint venture partner can simplify market analysis, streamline projects and improve outcomes in the following ways:

  • Local partners offer intimate insights into a city’s market dynamics and regulatory landscape and its residents’ needs. Leaning on this expertise enables outsiders to identify gaps and make informed investment decisions to reduce risk.
  • As locals and business operators, their community connections are expansive. Outside investors can tap into these networks to speed up the development process, reduce costs and expedite project timelines.
  • Learning the identity of a second-tier market is a crucial step for entering it successfully. Local partnerships enable investors to forge strong connections with community organizations, business associations and residents, and engage in meaningful conversations that will improve the investment approach.

Investing in untapped, second-tier markets can be profitable, but without institutional investors showing others how it’s done, those looking to enter the market must be creative, resourceful and adaptive. Leveraging both personal experience and insider insights will create greater potential for success.

By aligning development strategies with the unique characteristics and aspirations of cities such as Louisville, investors have the opportunity to shape their trajectory and create lasting value for residents and businesses alike.