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Working small markets

Brad Bonkowski

As a commercial real estate broker in a sub-sub market (Reno being a sub-market of the Bay Area, and Carson City being a sub-market of Reno), the majority of our firm’s transactions are relatively “small,” meaning under $5 million in volume, and a surprising number of these transactions are below $500,000. Sometimes investors purchase these smaller investments simply because that represents their price range. Often wealthier investors may reduce their risk by spreading their wealth amongst multiple small properties, and may additionally hedge their risk by spreading their investments amongst multiple markets, as well, in the hopes that if the real estate market tanks in Carson City, it may remain strong in Phoenix, San Antonio or Boca Raton. Aside from these obvious benefits, why would an investor choose to purchase an income-producing property in Carson City, for example, as opposed to somewhere in the Bay Area or Southern California, given the opportunity?

There are several reasons. First of all, simple price point is key. The average price of a duplex in Carson City right now is about $150,000. You won’t find a duplex in San Francisco at $150,000. Yes, the rents are higher in San Francisco, but typically, the return on investment is much lower. The return on investment, whether an investor measures in terms of capitalization rates or cash-on-cash returns, is often higher in smaller markets. For example, a tenant-occupied industrial investment with a solid credit tenancy might currently sell in the Bay Area at about a 6 percent CAP, whereas that same investment just sold in Carson City at an 8 percent CAP. There is a premium to be paid for low-hanging fruit those investments located in major markets as the risk is perceived to be lower. Look harder, climb higher up the tree and you can find equally choice fruit with better returns. After the roller coaster ride of the past five years, more and more investors are inclined to ignore the mirage of a “safe” investment in a big city or core market in favor of the higher returns that can be found in a secondary or tertiary market.

Secondly, small markets are usually unique in some way. Carson City is unique in that it is the state capitol, and therefore the employment base and the economy tends to be more stable than Reno or Las Vegas. An apartment investor who is attracted to Nevada’s landlord-friendly laws may actually believe (correctly) that the vacancy rates will remain more secure in Carson City than transient Las Vegas, for example. Most small markets have some unique characteristic that will appeal to a particular handful of investors: a university, a cluster of environmentally friendly businesses, or an aging, historic downtown ripe for redevelopment. As an example, Mound House, an unincorporated industrial area of Lyon County comprised of 600-plus acres immediately east of Carson City, has long been a favored area for small investors to find long-term tenants, mostly family-run machine shops.

Proximity to major markets is an interesting requirement of some small market investors. Investor competition or supply and demand can drive prices too high and returns too low in a primary market, while a smaller community a short distance away may offer the benefits of the larger market at reduced pricing. Dayton saw this at the height of the real estate investment market in 2005-2007, when the price of a four-plex skyrocketed to $650,000, only to fall to today’s dismal figure, typically under $200,000. That’s lower than it probably should be but corrected nonetheless. At the peak, Carson City did not have newer four-plexes for sale so the bedroom community of Dayton, 12 miles to the east, with its plentiful supply of product, was a popular alternative.

Investing in smaller markets isn’t without its pitfalls. One of the opportunities presented by investing in a small market also brings some challenges: local pride. While it’s good for a small community to have community members who want to invest in the city or town where they live, do business, and send their children to school, it can also present some unique problems. A smaller community may find that one or two individuals or families own the majority of a town’s main street, which may pose problems for a small business trying to negotiate reasonable rent or lease terms. Unsophisticated local investors may negatively affect a community’s vacancy rates by insisting that market rents are higher than they truly are, allowing prime commercial space to sit vacant. Of course, these problems may be found in any market, but in a smaller market, they appear magnified.

Some small investments are often more appropriate for a young (or new) investor who may be more willing to do management, maintenance and improvement work themselves. Opportunities exist in smaller commercial properties, in smaller markets, that just aren’t for everyone. Not every investor is prepared to deal with repositioning a troubled or blighted property. Passive investors are more likely to accept the lower rates of return of a “coupon-clipper:” a nationally tenanted investment property in a major metropolitan market.

Smaller markets may offer challenges in finding local brokerage talent. While a local industrial property specialist may be found in any major market in the country, the same may not hold true in a smaller community. This means that if your industrial property, purchased as a “deal,” becomes vacant, it may be more difficult to get it re-leased or find the talent necessary to reposition the property. For a number of reasons, an investment in a smaller market may require a longer hold period.

The truth is that anyone with money can invest in a major metropolitan market relatively safely, while profitable investment in a smaller market often requires a higher degree of expertise, due diligence, and talent. Fortunes are made where the greatest challenges appear, and challenge and opportunity typically appears together. A great amount of cash has been waiting the past three to four years for the best time to jump into the market, and experts agree, the time is now. Prices are low, opportunities are abundant and inflation lurks around the corner. The time to make money in real estate is now!

Brad Bonkowski, who has earned the CCIM designation, is a commercial real estate broker and principal with Coldwell Banker Commercial Premier Brokers in Carson City. Contact him at 721-2057.