Driving Alpha by Investing in Smaller Markets
Written by: Kevin Price
“If everybody is thinking alike, then somebody isn’t thinking”
—General George S. Patton
Southern Oak Capital (“SOC”) aims to differentiate itself by thinking about commercial real estate differently than others. To do this we rely on fundamental research to drive investment decisions. Key factors have been identified by Southern Oak Capital that, we believe, can be used by smaller commercial real estate funds to outperform larger commercial real estate funds over the long-term.
One of these factors is: small markets have more attractive valuations, wider cap rates, than larger markets.
Additionally, we find that, in certain asset classes, smaller markets also have stronger fundamentals than their larger peers. This dynamic can provide for stronger risk adjusted returns and generate alpha for a portfolio.1
Small Markets Over Large
For this research, we created two regions. The first region consists of the southeastern portion of the United States to central Texas (“Southeast Region”).2
The second region consists of New York, NY, Los Angeles, CA and San Francisco, CA (“NY, LA and SF Region”).
Data for these regions are shown in the charts throughout. As seen to the right, cap rates in the Southeast Region have spreads ranging from 170 to 238 bps over cap rates in the NY, LA and SF Region.
One factor that could be thought to explain the spread in cap rates is the vacancy rate. This seems to be the case in Retail, Office and Industrial. As seen in the chart to the left, spreads in vacancy rates rise along with the cap rate in the chart to the top right.
However, Multi-Family seems to disprove this. Multi-Family in the Southeast Region has a lower vacancy rate than the NY, LA and SF Region. Additionally, Multi-Family has one of the largest spreads in cap rates between the two Regions.
Furthermore, Multi-Family in the Southeast Region seems to be more attractive on all of the major key indicators that were observed.3
As shown in the chart to the right, Multi-Family in the Southeast Region has a more attractive cap rate, lower vacancy rate, stronger net absorption and less new supply coming to market.4
Another attribute that we theorized could be the contributing reason as to why cap rates are significantly different between the two Regions is liquidity.
As shown to the left, liquidity is mixed amongst the two Regions.5 For example, in the very early on months, the Southeast Region seems to have a slightly more liquid market. However, as properties stay on market longer, the NY, LA and SF Region begins to show stronger liquidity.
For us, we view liquidity as a risk we want to take on.6 We are able to mitigate some of the liquidity risk by: having an illiquid investment product, diversifying across markets and potentially having a small working capital line at Southern Oak Capital, LLC.
To learn more about our strategy please reach out to Andrew Chipman at achipman@southernoakcap.com
1 Data for charts and research from Costar. This data is pulled from comps in each of the respective markets over a one-year time frame
2 The mapping and polygon functions were used in Costar to create the region. It is a broad region consisting of much of the southeast along with the eastern side of Texas. Please reach out to someone at Southern Oak Capital for more information on the region
3 This is only a sampling of key indicators. There could certainly be key indicators in which the Southeast Region is less attractive. We attempted to use a handful of the more common indicators that we use to evaluate markets
4 All data from Costar and over a one-year time period
5 This chart shows the percent of properties sold within the timeframe shown on the chart. We are using this as a proxy for liquidity. Please refer to the Private Placement Memorandum for additional details.
6 Please see Private Placement Memorandum for a list of risk factors along with mitigants we use for some of the key risk factors
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