How the Other Half Builds: Small-Scale Development in Tertiary Markets

By: Shawn Moura, Ph.D., Director of Research, NAIOP

Release Date: December 2021

Institutional commercial real estate investors and large development firms usually focus on the largest commercial real estate markets, though many are also active in mid-sized markets. Often referred to as “primary” and “secondary” markets, these roughly correspond to the 50 largest metropolitan areas in the U.S. By comparison, smaller “tertiary” markets attract less institutional investment and subsequently less attention from researchers, analysts and trade publications. New office and industrial buildings that serve these markets also tend to be smaller on average than those in larger markets, since local demand supports fewer multistory office buildings and large distribution centers. However, while they may not be at the center of the action, tertiary markets are home to about half the U.S. population and represent a significant share of the commercial real estate market.

Real estate development and ownership in smaller markets differs from development and ownership in larger markets in ways that tend to deter large regional or national developers and favor local developers. This research brief draws from a survey of NAIOP members and interviews with developers in tertiary markets such as Western Michigan and Southwest Missouri to examine these differences and their implications for developers and investors. The survey revealed that the broader community of developers and building owners prefer large projects in primary markets over small building development in tertiary markets for a variety of reasons. Conversely, developers who are active in tertiary markets identified several advantages to smaller-scale development in these markets. These divergent perspectives reflect differences between the two groups in their business strategy, scope of operations and familiarity with smaller markets. Large development firms may have good reasons to avoid smaller markets, but that does not mean they do not present opportunities for local developers and investors. To the contrary, local developers frequently cite the absence of larger competitors as one of the advantages of doing business in smaller markets.

Key Findings

  • Building size usually reflects local demand for commercial space, with larger buildings concentrated in larger markets. Developers and investors that focus on economies of scale tend to avoid smaller projects, and consequently tend to favor larger markets.
  • Higher yields and fewer potential buyers favor longer holding periods in smaller markets. Higher exit risk may discourage developers with shorter time horizons from entering a tertiary market.
  • Due to limited market research and fewer commercial real estate transactions in smaller markets, local developers have an informational advantage over nonlocal developers, allowing them to better evaluate a project’s risks and return.
  • Developers in smaller markets can mitigate risk by limiting the volume of speculative projects they undertake and by developing strong relationships with local contractors, designers and prospective occupiers.
  • Although local and regional businesses continue to represent a larger share of occupiers in smaller markets than in larger markets, national firms have recently expanded their presence in smaller industrial markets alongside broader growth in e-commerce distribution.