Homo sapiens. Tyrannosaurus rex. Canis lupus. Latin-based scientific names are consistent, predictable and allow for easy categorization of different species. Before binomial nomenclature was formalized in the 1700s, species names were descriptive, resulting in names that were often composed of long strings of descriptive words. As more species were discovered, this became increasingly confusing to keep track of. Today, classifying property markets has many of the same challenges.
There is no shortage of reports out there dividing cities into Class A versus Class B markets or primary versus secondary or tertiary markets. These classification systems might rank markets based on opportunity and risk, population growth, income, inventory, cap rates, or any number of other factors. And this is to speak nothing of the qualifiers like “gateway city” or “24-hour city” that further complicate things. Without standardization, and with so many different purposes and methodologies out there behind the different ranking systems, there is little ability for property investors, academics, and observers to compare markets, apples to apples, without substantial groundwork and problem solving for regional differences. In some instances, this is only an annoyance if the metrics a given investor would look for aren’t part of the classification systems. But in others, it can be an even bigger problem, causing practitioners to doubt the bias and integrity of a given classification system. Is the data accurate and valid, or have variables been chosen to make a certain market look a particular way?
In reviewing the numerous market classification systems out there already, NAIOP’s researchers, Maria Sicola, Charles Warren, and Megan Weiner, all founders of urban data firm CityStream Solutions, came to understand that most systems often classify based on either market size or market risk and opportunity metrics like cap rates. But neither individual measurement is enough to give practitioners a good sense of a market at a glance, and indeed, markets that are strong in one metric often come up short in the other. Big markets are often not the most dynamic markets.
This is the situation that NAIOP sought to rectify when one of their reports introduced a new matrix-style market ranking system earlier this year. According to Charles, “trying to take those two categories of variables that don’t necessarily relate to each other directly or proportionately and squeeze them down into a single ‘primary, secondary, tertiary,’ ‘first, second, third’ doesn’t make sense anymore.” Like staring at an unfiltered Excel sheet without cross-tabulating the data, overall usefulness winds up underwhelming. So the researchers started to think about an alternate way to sum up different markets in comparison. In essence, a binomial nomenclature for property markets.
“Someone at NAIOP pointed out that Morningstar has an existing thing they call a style box that they use to describe, not necessarily rate, funds, stocks, or other investment vehicles,” Charles said. The Style Box matrix considers company size on one side and valuation on the other side. The researchers found that that approach works well for property markets, too. So the researchers came to recommend a similar approach to categorize property markets—a two-dimensional model that accounts for size of market on one axis and risk/opportunity on the other axis.
Such a matrix of real estate markets would allow practitioners and researchers to quickly understand how different cities stack up in a more comparative fashion, with a given city sitting anywhere on a continuum of large to small and stable versus growth. Charles explained that “there are definitely investors who want to pay attention to smaller markets that may have faster growth rates but faster volatility.” A two-dimensional matrix is much more useful for this kind of investor while retaining its usefulness for the big investment shops who look for core opportunities in the biggest, most stable cities.
There is an interesting feedback loop between real estate research and tools and the business itself. Many of the traditional classification systems wind up with the biggest, most stable markets on top, while the new two-dimensional matrix, by avoiding the single-purpose straightforwardness of numeric ranking systems, allow investors to hone in on whatever cities strike their fancy. And indeed, interest in smaller, less stable markets has been rising for some time. In terms of 2020 single family residential price growth, none of those big stable markets are in the top 25. Instead, cities include less familiar names. The top three spell it out clearly: Boise, ID; McAllen-Edinburg-Mission, TX; and Tucson, AZ. On the commercial side, CBRE foresees activity in secondary and tertiary markets continuing, explaining that “although appetite for risk generally is decreasing at this late stage in the cycle, some investors continue to look for higher yields given the low cost of capital.”
That kind of investment activity, focusing on smaller markets, is more possible now than ever before. The internet and the plethora of tools that it has brought to bear means investors anywhere, even in the downtown hearts of the biggest, most stable markets, have an unrivalled opportunity to place capital sourced from across the globe into markets that might have been impenetrable even two decades ago. Changing investor tastes and tolerances dovetail with this growing capability, meaning many now have the inclination and opportunity to go where the deals are, wherever that may be. Advances in the research and understanding the underpinnings of the real estate world, like this NAIOP report, are both a result of and a benefit to this wave of investor interest. And so the cycle continues.
Opportunistic investors should rejoice because the real estate world is experiencing a veritable renaissance of possibility. It has never been easier for buyers of all types of property to find the right markets, the right submarkets, and the right properties for their individual risk and reward preferences. The two-dimensional matrix approach is a part of that renaissance, and it does so while retaining 100 percent of the usefulness for bigger investors looking for the safest investments, too. We may not quite be at the level of full-on biological binomial nomenclature, but a matrix-based approach brings the world of verus praedium a little closer.