The Great Sub-Market Debate

Experienced real estate investors know that the investment value of a property is predetermined by the cash flows generated from the property. These cash flows are both incoming and outgoing. If the demographics surrounding the property are strong, this helps to reduce vacancies, thus improving the rate of uninterrupted cash flows during the holding period.

These are basic fundamental real estate principles. They are real, and they are timeless. It makes no difference if a property sits in a core market, or a sub-market. If the market is vibrant with strong employment, demographics, and the numbers make sense, then you know you have a deal worth considering. Oddly enough, many REITS shun properties located in sub-markets without even a second thought.

A Brief and Generic Case Study:

What if you found a property that could generate enough cash flows to produce a 34% return on investment within five years?

Let’s take a closer look at this scenario:

Here are the cash flow projections for this particular property:

The CASH FLOWS:

Initial Equity (Year 0)    ($3,400,000.00)
Year 1    $405,404.00
Year 2    $477,993.00
Year 3    $549,149.00
Year 4    $625,329.00
Year 5    $706,891.00

Resale Value    $23,843,379.00

PV @ 15%    $22,621,466.24
Less Mortgage Bal    ($12,552,132.00)

Net Present Value    $10,069,334.24

Return on Investment of $3,400,000.00:    34%

Big Buyer Group Think: Location over Profitability

For all accounts and purposes, this looks like a profitable scenario. However, many institutional investors–including REITs–would not even look at this deal because it is located within a sub-market. I understand the perspective that asks the question, “Why should we pay a 6% cap rate for a property in a sub-market when we can purchase property at a 6% cap rate in a core market?” However, I would like to point something very important to all the smaller real estate investors out there. Leaving money on the table without consideration is a big mistake.

When smaller real estate investors begin to recognize the money that has been left on the table by the larger institutional buyers. It is indeed a “blue ocean” of opportunity, because the big companies are too inflexible and too rigid to recognize opportunity outside of their normal view of the way things are. In May of 2011, Mortgage Banking Magazine quoted Alan George–the CIO of apartment REIT Equity Residential, “…there were so little class-A assets. There were so few nationwide in core markets that it was a completely useless endeavor,” George said. “There are distressed assets, there still are in some of these tertiary markets, but who wants to buy those?”

I beg to differ by answering the question, “who would want to buy golden opportunities in strong submarkets?” Why, smart and experienced real estate investors would, because they know to look at the numbers and surrounding economic factors of the area. A strong market is a strong market whether it is a core or a sub-market.

To the smaller real estate multifamily investor, I say, there is a blue ocean waiting to be captured. Use the “big-buyer group think” syndrome to your advantage.