worth $50 million or less represented over 90% of the transaction volume during the periods shown. Thus, larger yields seem to be available simply because of capital ineffi- ciencies in those markets.

Capitalization Rates in Major Metropolitan Areas vs. Non-Major Metropolitan Areas





MIDDLE MARKET SECTOR In addition to the apparent reduced financing competition in the middle market sector, there are other potential benefits of this space. “The prices in the small-cap CRE (commercial real estate) domain don’t have the same peaks and valleys as the large CRE market,” said Randy Fuchs, principal at Box- wood Means, a research group that surveys trends in smaller commercial properties. In addition, some of the market’s attractiveness can be ascribed to a continued relatively lack of new construction projects. The pace of construction in Q2 2015 was at just 40 percent of the long-term quarterly average rate, and even today construction financing seems to remain difficult to find for middle market properties. “It is a bit of a head-scratcher that developers of smaller buildings have not responded to the very tight vacancies that exist in the small-cap domain,” Fuchs said. Developers seem to be more focused on higher-end properties where there is a better prospect of recouping the related construction costs. Finally, because rents in gateway markets have become so expensive, at least some tenants seem to be moving to the suburbs.


TheAdvantages of “Middle Market” Commercial Real Estate THIS OFTEN-OVERLOOKED ASSET CLASS OFFERS HUGE POTENTIAL.



by Lawrence Fassler



values. Under the right circumstances, these comparatively under-appreciated cities—Denver, Phoenix, and Dallas are good examples—can potentially offer investors an attractive opportunity. Global investors don’t seem to chase the small- balance market, for one thing. Another differentiator is that the middle market commercial market tends to move more in tandem with the residential housing space, which has also ticked up as of late. Notably, many of these second-tier cities also boast strong job growth. WHAT DO THE DATA SHOW? Of course, it’s all well and good to tell a story about elongated cycles and un- dervalued markets—but do the data bear it out? The answer seems to be yes. The below graph on the opposite page, utilizing data obtained from Real Capital Analytics (RCA), illustrates the potential middle-mar- ket advantage by showing average capital- ization rates in major versus non-major metro areas. (A cap rate is the ratio of a property’s net operating income to its current market value, with higher cap rates

often considered – all other things being equal – relatively more advantageous for buyers and investors.) As one can see, properties in non-major metro areas have historically been financed at higher capitalization rates, likely indi- cating that capital has been less available in those non-major markets. This differential is sometimes attributed to the perceived difficulties faced by larger institutional investors in dealing with investments of less than $10 million. Assuming it costs those fi- nanciers about the same amount to process and underwrite a particular transaction, their time would naturally be spent on the larger opportunities where the absolute returns are accordingly higher as well. The same principle holds when a single non-major metro (Dallas) is compared with a major one (Los Angeles). The first graph to the right shows a positive cap rate differential regardless of the gross asset value (GAV) of an underlying property. The second and third graphs suggest that even within a single market, capital availability remains dependent on transaction size. This financing gap is especially signifi- cant since transactions involving properties

veryone likes a trophy, and glamorous properties in big

cities have certainly benefited from the recent strong real estate market. But much less attention has been paid to the resurgence of “middle market” commer- cial properties. We’ll explore here the opportunities offered by smaller-value transactions in areas not considered “gateway” markets. The perception that some real estate markets may be over-valued has been driven, in part, by the appreciation of trophy assets in gateways cities like New York, Boston, Chicago, and San Francisco. These are the cities to which institutional and foreign investors often turn when real estate comes out of a re- cession. As a consequence, the “upside” in these markets can increasingly dry up as a business cycle elongates. In such a late-cycle market, investors often seek properties in secondary markets that offer higher yields and better LESS A TROPHY, MORE AWORKHORSE










Source: RCA. Includes multifamily, office, industrial, retail and hospitality transactions with individual transaction sizes of less than $50 million during the trailing 12 months (as of June 30, 2017). Major metro areas include Boston, Chicago, Los Angeles, New York, San Francisco, and Washington, D.C.

Historical Cap Rate Differential Between Dallas and Los Angeles

Historical Cap Rate Differential for Los Angeles By Transaction Size

> Continued on :: PG 96

Lawrence Fassler, an attorney and real estate investor, is Corporate Counsel of RealtyShares, a leading real estate in- vestment marketplace that places equity

investments through North Capital Private Securities Corporation; a registered Securities broker-dealer, and member of FINRA/SIPC. RealtyShares as an institution does not advise on any legal issues, and this article is for general information only and does not represent professional legal advice. Contact the author at



Office Ind Lodging



Office Ind Lodging

Source: RCA. Historical capitalization rates from 2001 to 2016.

Source: RCA. Historical capitalization rates from 2001 to 2016.

46 | think realty magazine :: june 2018

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