What Are Real Estate Market Tiers?

DEFINITION:

The major U.S. metro areas are divided into three tiers according to the maturity of the real estate market.

Key Takeaways

•Investment companies use real estate market tiers to segment cities based on size and development.

•Tier 1 cities are the safest for income opportunities while Tier 2 cities present strong growth opportunities.

•Pay attention to population growth. If Tier 1 cities start to experience degrowth, investment returns will suffer.

•The existing tier system isn’t perfect, and some real estate groups are advocating for a new, multi-dimensional approach.

Definition and Examples of Real Estate Market Tiers

Real estate market tiers segment the real estate market by how established the location is.

Tier 1 cities, such as New York City, have well-established markets that may not see much additional growth. Tier 3 cities are less developed with lower populations and may not have the infrastructure or population support for major real estate investments. Tier 2 cities, such as Denver, are somewhere in between.

How Do Real Estate Market Tiers Work?

The tiers are used by investment research companies and real estate firms to segment investments. Some REITs will pitch themselves as only investing in Tier 1 markets. This is important for investors looking for steady income. Tier 1 markets are more likely to always have a supply of new tenants looking for space.

Businesses can use the tiers for expansion as well. Tier 2 cities will have the ability to house a large back-office operation while also having a low enough standard of living that premium wages do not need to be paid. That said, if the economy turns downward, businesses may focus on Tier 1 cities to stay conservative.

Here’s a closer look at each tier.

Tier 1

Each investment company has its own ranking system, but most put cities like New York, Los Angeles, and Boston into Tier 1. These are cities that have massive populations, decades of real estate growth, and a thriving market.

Tier 2

Many investors view Tier 2 cities as the best investment opportunity. There is infrastructure for new investment but the market is not yet saturated. Tier 2 cities may include places such as Denver, Kansas City, and Salt Lake City. Tier 2 city populations generally range from 1 million to 5 million people.

Tier 3

Tier 3 markets typically have low populations. Some people rate all cities with a population under 1 million as tertiary, and some go as low as under 100,000. Tier 3 markets can be a great opportunity if there is a reason for population growth.

Alternatives to Market Tiers

The existing market tier system is far from perfect. Most practitioners have their own proprietary model for determining which cities go into which tiers. This often ends with tiering being done with the audience in mind instead of based on fixed, objective criteria.

Additionally, Tier 1 cities are sometimes promoted as being the best investment option despite the fact that they are inherently saturated with investment.

Tier 2 city classification isn’t much better with this approach. Depending on the source, you could find cities as diverse as Salt Lake City, Dallas, and Baltimore referred to as Tier 2. Each of those cities would provide totally different opportunities and challenges for real estate investors.

In 2020, the Commercial Real Estate Development Association, also known as the NAIOP, published a report suggesting that an alternative fixed system would serve investors and developers better.

The NAIOP suggested a multi-dimensional system, similar to the way the Morningstar Style Box makes a two-dimensional comparison of mutual funds.3 This would allow investors and developers to sort markets by size and risk/reward opportunity. Instead of just viewing markets by size and cramming the majority of markets into Tier 2, investors could see which markets offer the best opportunity for their specific goals.

What Real Estate Market Tiers Mean for Individual Investors

Real estate market tiers are good to know for individual investors seeking to invest in REITs or other commercial real estate products. You need to understand the lingo to be able to read the prospectuses and make smart investment decisions.

Don’t be surprised if real estate in Tier 1 cities performs poorly over the next decade or so. The surge in remote work brought on by the pandemic has led to an exodus from big, expensive cities. If this trend continues, there may be no reason for companies to pay premium prices for space in Tier 1 locations.

You can also create your own proprietary tiers in areas close to you for commercial real estate investment. If the closest major metropolis is your Tier 1 city, then which suburbs are Tier 2 and which are Tier 3? How would they all fit on a multi-dimensional system? It may be helpful to work through this process when targeting new opportunities.

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