The categories of the real estate market in major cities in the United States are divided into three categories based on the level of market establishment. Investment firms use real estate market categories to segment cities based on size and development. Tier one cities are considered the safest for income opportunities, while tier two cities offer strong growth potential. Population growth must be monitored closely. If tier one cities begin to experience a decline in growth, investment returns will be affected. The current system of categories is not ideal, and there are some real estate groups calling for a new, multi-dimensional approach.
Definition and Examples of Real Estate Market Categories
The categories of the real estate market classify the real estate market based on the level of site establishment. Tier one cities, like New York City, have well-established markets that may not experience much additional growth. Tier three cities are less developed due to lower populations and may not have the infrastructure or significant population support for large-scale real estate investments. Tier two cities, like Denver, fall somewhere in between the two categories.
How Do Real Estate Market Categories Work?
The categories are used by investment firms and real estate companies to segment investments. Some real estate investment trusts may position themselves as investors only in tier one markets. This is significant for investors seeking steady income. Tier one markets are likely to always have a fresh supply of tenants seeking space.
Companies can also use the categories for expansion. Tier two cities may have the potential to host a large back-office operation with a cost of living low enough to avoid high wage requirements. However, if the economy declines, companies may focus on tier one cities to remain conservative.
Alternatives to Real Estate Market Categories
The current system of real estate market categories is far from perfect. Most practitioners have their proprietary ownership models to determine which cities belong to which category. This often results in categorizing based on target audiences rather than relying on fixed, objective criteria.
Additionally, tier one cities are sometimes promoted as the best investment option despite being naturally saturated with investment.
Classifying tier two cities is not much better with this approach. Depending on the source, you may find diverse cities like Salt Lake City, Dallas, and Baltimore edging toward being categorized as tier two. Each of those cities will offer completely different opportunities and challenges for real estate investors.
In 2020, the Commercial Real Estate Development Association, also known as NAIOP, published a report indicating that a fixed alternative system would better serve investors and developers. NAIOP proposed a multi-dimensional system, similar to the Morningstar Style Box methodology used to compare mutual funds in two dimensions. This would allow investors and developers to classify markets by size and risk/reward opportunity. Instead of merely presenting markets by size and squeezing most markets into tier two, investors could see which markets offer the best opportunity for their specific goals.
What Do Real Estate Market Categories Mean for Individual Investors?
Real estate market categories provide valuable information for individual investors looking to invest in asset-backed real estate investment trusts or other commercial real estate products. You should understand the terminology to read offerings and make smart investment decisions.
Don’t be surprised if properties in tier one cities underperform over the next decade or so. The rise of remote work spurred by the pandemic has led to an exodus from large, expensive cities. If this trend continues, there may be little reason for companies to pay high prices for space in tier one locations.
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Also create your own categories in the areas near you for commercial real estate investment. If the nearest major city is your primary city, which suburbs are classified as the second tier and which suburbs are classified as the third tier? How can all of them fit into a multi-dimensional system? It may be helpful to work through this process when targeting new opportunities.
Source: https://www.thebalancemoney.com/real-estate-market-tiers-5207240
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