If You Build It, They Will Come–Harnessing Upside Potential in Tier 2 and Tier 3 Markets

It might look a bit like a baseball diamond to the untrained eye, but to the development team at DLP Capital, this 18-acre parcel below is a home run in the making, situated in the Tier 3 market of Sevierville, Tennessee.

It’s just this type of tertiary market that DLP Capital keeps its eyes on, given that Tier 2 and 3 markets are often ignored by other investors, which exacerbates rental housing voids but provides excellent opportunities for investment and upside potential. So exactly what are Tier 2 and Tier 3 tertiary markets? More on that below. But first, back to Sevierville.

Villas at Sevierville under development in a Tier 3 market

It’s just this type of tertiary market that DLP Capital keeps its eyes on, given that Tier 2 and 3 markets are often ignored by other investors, which exacerbates rental housing voids but provides excellent opportunities for investment and upside potential. So exactly what are Tier 2 and Tier 3 tertiary markets? More on that below. But first, back to Sevierville.

You might otherwise have never heard of Sevierville, except it’s home to Dollywood theme park—the most visited attraction in Tennessee—drawing 3 million visitors annually to its rides, theaters, and restaurants. The diamond-shaped mound pictured above is situated at the main intersection leading into that park. That prime location will soon become home base to Villas at Sevierville, a Class-A multifamily community with over 300 units. Currently, there is minimal workforce housing available in Sevierville, with the local housing market characterized by older, smaller apartment complexes. The new high-quality and modern community will add much-needed new rental units to the theme park vicinity. The area also benefits from a diverse economy that includes hospitality, retail, construction, and healthcare, and just beyond this development can be seen the Great Smoky Mountains National Park, and nearby is also a NASCAR Speedpark. Tier 3 markets like this—smaller cities and suburbs that hold high potential for harnessing growth in real estate values—can have their big draws.

Tertiary real estate markets may have fewer barriers to entry and more upside potential.

Tiers 1, 2, 3 Explained in Brief

The largest metro areas in the US, global cities such as New York, Boston, and Los Angeles, are considered Tier 1. They’re the most mature real estate markets—and also the most competitive and expensive. This makes it challenging for acquisitions and developments to pencil out given that there’s less land, it’s hard to obtain entitlements, there are fewer incentives, and there are higher construction and operating costs. These big-city markets may also be saturated with investor capital, thus offering lower returns on investments.

Tier 2 markets, on the other hand, include cities with solid fundamentals that have not yet reached their full potential—hence the opportunity for greater investment upside. These markets, such as Dallas, Charleston, Charlotte, Orlando, and Jacksonville, may have underpriced assets and price elasticity, along with fewer barriers to entry. Their local governments may be more apt to provide development incentives, and in general the cities may be less expensive places in which to live, work, play and run a business compared to their larger counterparts. Many Tier 2 cities, with populations ranging from about 1 million to 5 million, have also been experiencing positive demographic shifts as Americans seek improved quality of life beyond the big cities.

Tier 3 tertiary markets are gradually transforming and include smaller cities—populations under 1 million—and suburbs that hold high potential for harnessing growth in real estate values. There’s typically limited competition and low entry costs. These markets may hold tremendous upside potential, especially given low basis prices, but that must be balanced with consideration for exit strategies; compared to Tier 2 markets, there may be less interested players when later seeking to sell an asset.
 

Investment “Price Per Door”: $100K more in Big Cities

A good example of the lower cost of entry to Tier 2 and 3 markets was evidenced in a portfolio of 10 multifamily properties in which DLP Capital invested in 2022. The portfolio, valued at nearly $500 million, consisted of properties located in Tier 2 and 3 markets in cities such as Columbia, SC, Greenville, NC, and Indianapolis and Oklahoma City, among others. The “price per door” for units in the portfolio was only about $155,000; in a Tier 1 market that price can easily be upwards of $250,000 per door. The portfolio properties were primarily in suburban-metro areas and had the added benefits of no new multifamily supply within a five-mile radius of any of the properties—virtually no competition. That can rarely be said of Tier 1 markets.

In short, while mid-size to smaller cities and suburban markets might be off the radar for very large investors drawn to large cities, such as hedge funds, Tier 2 and 3 real estate markets can hold extraordinary potential for above-market investment returns—given appropriate local market knowledge, strong sponsors, proper due diligence, and strong ongoing asset management.

Build up those multifamily investments in tertiary markets poised for growth—and the tenants will come, as will the opportunities for superior returns.

Sample tiers of cities