This is something that has puzzled me as I've moved from the AEC side of the business to the finance side.
There is a group of elite, prestigious RE companies. They tend to hire from target schools, and many of the posters here would like to work for them. You know their names: Hines, Brookfield, Related, Tishman Speyer, Boston Properties, and so on. As far as I can tell, they all focus on big, Class-A properties in core cities like NYC, DC, SF, etc. And cap rates in these markets are super low.
This seems like the RE equivalent of MBAs going to work for top hedge funds where they outbid each other for Apple stock. At a certain point, Apple's share price gets way too high. And you'd think the hedge funds would start looking at some boring widget manufacturer in Alabama with a lower P/E ratio.
Why does this situation exist in CRE? Some possible reasons:
1. I'm wrong on the facts. The most elite RE companies actually do have significant exposure to smaller properties in secondary and tertiary markets, and I'm just unaware of this.
2. Don't confuse "elite" with "successful". Everyone wants to work for Related because they're doing Hudson Yards, but there are other large, sophisticated RE companies that are doing better than Related or Hines. You just don't hear about them as much because they invest in boring things.
3. Yes, large Class-A properties in global gateway cities DO provide the best risk-adjusted returns over the long term. The famous companies above are the best-capitalized and most sophisticated operators, and so they are the ones who can actually execute these expensive, complex deals. Lower-tier companies do smaller deals in secondary markets and earn lower risk-adjusted returns in the process. Sucks to be them.
4. It's too hard for elite companies to access high yields from smaller buildings at scale. These firms have tons of capital that they need to deploy quickly and efficiently. It's way easier to do due diligence, negotiation, and closings on several huge high-rises than on hundreds of small buildings. (But why not buy a portfolio of small buildings in one fell swoop after a smaller investor gradually assembled it?)
5. There are operational efficiencies associated with large buildings. It's cheaper and easier to manage several huge high-rises than to manage hundreds and hundreds of three-families. (Of course, this is just another way of saying that that the risk-adjusted returns are better in the former than in the latter, other things being equal. And a sufficiently large cap rate spread should offset the inefficiency.)
6. The elite companies are reducing their probable returns, but they're doing so as a hedge against downside risk. The property markets for Class-A buildings in top markets are highly liquid and contain many deep-pocketed players. The elite companies will accept lower returns on their assets because they know they'll find someone to take them out of a deal at a decent price if necessary. By contrast, there might be only one legit counterparty operating in a smaller market.
(A higher-up at one of the elite firms listed above made this argument to me. I get it, but it sounds more like a first-mover issue than a fundamental financial one. I.e. no one is doing it, because no one is doing it. And you'd think someone would take the risk if the yields are significantly better in a secondary or tertiary market.)
7. The market isn't efficient. These companies really could make more money buying smaller buildings in smaller markets, but they want trophy assets because their executives are on ego trips.