Bob McMahon: Investing in Tier 2 Schools is Great for Your Bottom Line

Bob McMahon Bob McMahon

Now is an opportune time for developers and investors to consider investing in the Tier 2 student housing real estate market. As the Tier 1 market becomes crowded and overly competitive for both investors and developers, Tier 2 student housing markets are becoming more popular with students and giving investors greater yield and room to grow.

Where It All Began

Following the last economic downturn, most student housing developers focused almost exclusively on Tier 1 markets, largely because these were viewed as “safe” investments by both equity and debt sources.  Like all commercial real estate markets at the time, access to what limited capital was available largely controlled where projects were developed.

As capital availability has increased rapidly in recent years, most developers have continued to focus on Tier 1 markets because the largest capital providers, agency debt and student housing REITs have remained focused primarily on these markets. However, as development in these markets exploded to deploy the sudden abundance of available capital, developers have had to search further from campus for available land and, therefore, had to compete for residents through high-cost, low-retention amenity packages.

During this time, as development increased at the Tier 1 schools, the enrollment growth of Tier 2 schools was increasing, driven by limited job opportunities due to the recession, as well as many Tier 1 schools capping their enrollment. The result was Tier 2 markets seeing a rapid, immediate increase in housing demand.

What This Means for Investors 

There were very few purpose-built student housing communities with the amenity packages that today’s students have come to expect built in Tier 2 markets during the last cycle. The typical Tier 2 school, especially those relying on availability of public funding, generally did not have the capital in their budgets to build the additional housing to meet rising demand.

Opportunistic developers and investors looking into these Tier 2 schools have found that they are able to acquire very well located land, adjacent to campus, allowing for the development of a truly pedestrian community integrated with the campus. This allows investors to avoid poorly located properties that must compete solely on larger and costlier amenity packages.

Tier 2 schools often view private development as a benefit and an attraction to campus rather than as competition.  They are seeing modern, amenity-rich housing options close to campus as a way to compete with Tier 1 schools for top-tier students.  It fills a significant need for increasing enrollment, allowing Tier 2 schools to deploy their funds into academic programs and on-campus buildings.

Schools in these markets are far more receptive to new developments and interested in engaging in joint marketing or program planning.  This open relationship with campus administration secures long-term viability of the project for investors. 

Benefits of Investing in a Tier 2 Market 

As discussed briefly above, developers and investors often have several developable sites available for a student housing community in Tier 2 markets. With relatively little to no competition, there is an abundance of land available adjacent to or close to campus.  Tier 2 schools are also more receptive to your project, unlike Tier 1 schools that already have a competitive market. Because many Tier 2 schools rely on public funding, they don’t have the means to build new student housing on or near campus, even though they have high demand for it, so when investors and developers come to them with a new student housing project, they are much more receptive.

In comparison to many Tier 1 markets, return on cost can be higher than in Tier 1 markets. This is due to the increasing high-cost amenity packages needed to compete in Tier 1 markets to attract students, as well as Tier 2 schools being located in secondary markets, often leading to lower construction costs.  While one may assume that projects in Tier 1 markets attract higher rents, many Tier 2 schools can support equally high rents due to lack of competition and proximity to campus.

While the large exit capital sources, such as agencies and student housing REITs, still prefer Tier 1 markets, they are beginning to look more at Tier 2 markets due to higher yields available. However, more and more private investors are attracted to purchasing stabilized projects in Tier 2 markets because of the numerous benefits combined with less competition from the institutional investors.

To create the greatest amount of competition, and therefore value, for a Tier 2 project, stay at schools with an enrollment of at least 10,000 students and growing.  With more limited competitive properties to analyze, it is also important to scrutinize market demand and student demographics to ensure that full occupancy can be achieved at the assumed rents. 

Where to Find Tier 2 Market Opportunities

Investors can find these investment opportunities by participating in private partnerships for projects with experienced partners.  These partners, or “sponsors,” provide investors with all of the due diligence on a project and co-invest with investors, aligning their interests.  These investments often offer a preferred return to investors, prior to the sponsor attaining a return on their investment.  The sponsor also should provide any loan guarantees required by construction or permanent lenders.

If you’re looking for prime real estate in the student housing market and a better yield than the Tier 1 markets currently offer, investing in a Tier 2 market might be the opportunity you’ve been waiting for. 

— Bob McMahon is the co-founder of Stonemont Financial Group, a national real estate investment firm specializing in structuring and sponsoring single-tenant net leases for sale-leasebacks and new development build-to-suits, and student housing investments. For more information about Stonemont Financial Group please visit www.stonemontfinancial.com

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