Secondary Midwest Markets

Secondary Midwest Markets: Investor Refuge or Flavor of the Month?

by Sarah Daniels

More than a few column inches in multifamily media this year were dedicated to the implications of coronavirus on the housing preferences of renter households. Many theorize that the pandemic is leading householders to reexamine their attachment to urban life and consider suburban alternatives that offer larger floor plans, better schools, free parking and unit access without an elevator ride.

Available data suggest there is something to this notion. Occupancy and rent in core urban neighborhoods in the primary markets have declined, substantially in the highest-cost cities. Suburban performance, by contrast, is strengthening.

What is less certain is whether the same phenomenon is working to the benefit of secondary markets as well as big city suburbs. The jury is still out but investors already have stepped up acquisitions in the Sunbelt growth markets to exploit the opportunity — Austin and Phoenix were among the nine most active property markets in the third quarter, and Raleigh and Charlotte were just a step behind – but what of the staid and stable Midwest?

Columbus, Indianapolis and Kansas City (the “Midwest Three”) stand out among Midwest cities as the secondary markets most likely to attract gateway city refugees. Each offers renters most of the lifestyle and cultural amenities available in the primary markets but on a smaller scale and at more affordable cost. Have these simple virtues translated to better market performance?

View higher resolution version of chart above here.

By way of employment trends the Midwest Three was a mixed bag during the pandemic recession. Indianapolis and Kansas City posted some of the country’s best job numbers during the recession so far. Expressed on a seasonally adjusted basis, Indianapolis payrolls declined only 3.9 percent between February and September, materially better than the 7.0 percent U.S. average drop and, in fact, the third-smallest setback observed among the 50 largest U.S. apartment markets after Colorado Springs and Salt Lake. Kansas City was only slightly weaker, ranking ninth with a 4.7 percent decline.

Columbus was the negative outlier. Metro payrolls plunged 8.1 percent between February and September, in part due to the metro’s heavy exposure to the hard-hit higher education and healthcare sectors, ranking only 34th in the top 50 markets. Wage growth also lagged, rising on a 2.5 percent year-on-year trajectory over the first nine months of 2020, less than one-half of Indianapolis’s 5.3 percent surge.

Regardless, apartment market performance was in each case among the most resilient in the country. From February to September, the average occupancy of stabilized, same-store properties surveyed by Yardi Matrix increased 34 basis points (0.34 percent) in Indianapolis and 17 basis points in Columbus, and declined only 1 basis point in Kansas City, resting in September at an average of 94.32 percent. Among the primary and major secondary markets only Atlanta, Denver and Phoenix recorded better pandemic-era occupancy stability.

Likewise, Midwest Three rent growth trends were nearly unaffected by COVID-related job and income losses. From February to September, respective unit-weighted average same-store rent increased 1.77, 1.49 and 2.54 percent in Indianapolis, Kansas City and Columbus, and all property rent advanced 1.78, 2.29 and 2.00 percent. By way of comparison, all property rent fell in the eight primary markets by an average of 3.37 percent and dropped 0.46 percent in the Sunbelt growth markets (Austin, Charlotte, Nashville and Raleigh). Among major secondary markets (Atlanta, Chicago, Denver et al.), rents increased by an average of only 0.15 percent.

Similarly, the Midwest Three outperformed in the Class A/B+ and urban submarket segments that attract the king’s share of institutional investment dollars. Pandemic-era rent growth in the A/B+ segment was 1.21 percent or faster in each of the Midwest Three (Columbus posted a 2.22 percent gain), compared to -4.4, -1.6 and -0.6 percent in the primary, major secondary and Sunbelt growth groups, respectively.

With respect to core urban neighborhood rent growth, unit-weighted average same-store rent increased 2.22 percent in Columbus infill submarkets, 1.39 percent in Kansas City’s Downtown and University/Plaza neighborhoods and 0.61 percent in Indianapolis’s Central and Downtown submarkets. Conversely, core urban submarkets in only Charlotte, Dallas, Fort Lauderdale, Minneapolis and Phoenix recorded rent increases in the comparable period; in most cases at slower rates.

Performance data bear out that the Midwest Three markets represented attractive defensive plays during 2020’s volatile markets. For investors, they also offer higher going-in yields than any of the other markets analyzed. Cap rates are at least 50 basis points above comparable levels in Chicago and the Twin Cities, and 100 basis points higher than the cheapest primary and Sunbelt growth markets. For intermediate holding periods, these pricing and performance characteristics may translate to expected total return advantages of 150 basis points or more.

Although not suited to every taste or portfolio, these three markets appear to have earned their moment in the spotlight. If recent changes in renter behavior prove to be more than transitory phenomena, investors may want to give them a second look.

— By Daniel J. Hogan, Lument (formerly, ORIX Real Estate Capital) Managing Director for Research. Lument is a content partner of REBusinessOnline. The views expressed herein are those of the author and do not necessarily reflect the views of Lument or of the author’s colleagues at Lument.

For Hogan’s insight into other markets, click here.

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