The real estate rebound will continue in the coming year, but investors will turn to secondary markets in search of higher yields.

San Francisco is tops once again. But the Washington, D.C., market—ranked first as recently as 2011—has fallen to the middle of the pack. What was once viewed as an asset for the D.C. area—the influence of the federal government on the local economy—is now seen as a liability, with concerns caused by the federal shutdown compounding ongoing uncertainty about cuts in government spending.

Real estate professionals still cite San Francisco as the U.S. market with the best prospects. But, as prices for the best assets in core markets continue to escalate and opportunities there become harder to find, investors in U.S. real estate are looking beyond some of the traditionally popular markets in search of higher yields, according to Emerging Trends in Real Estate® 2014, copublished by ULI and PwC US.

Many investors who have traditionally focused mainly on large, established markets such as Boston, Chicago, Los Angeles, New York City, San Francisco, and Washington, D.C., in order to protect their capital say they will expand their focus to other cities in 2014. This trend, first noted in last year’s Emerging Trends report, is likely to build substantial momentum as the year progresses, given the steady pace of improvement in market fundamentals in secondary markets, and with more investments in those markets meeting investors’ risk/return metrics.

The movement into secondary markets is underpinned by the anticipated increase in both debt and equity capital during 2014. Emerging Trends survey respondents were particularly optimistic about the prospects for equity capital from foreign investors, institutional investors, and private equity funds, as well as debt from insurance companies, mezzanine lenders, and issuers of commercial mortgage–backed securities.

“The anticipated interest in secondary markets by investors is indicative of how far the U.S. real estate recovery has come,” says Patrick Phillips, ULI’s chief executive officer. “Only a few years ago, many investors were fearful of straying too far from large blue-chip markets, but now access to greater amounts of both debt and equity—combined with a sustained improvement in the underlying economic fundamentals—means that the opportunities and returns offered in smaller markets are once again very appealing.”

The key threats to market recovery, notes Emerging Trends, are the timing and pace of any interest rate increases. The report forecasts modest rate increases in the short term, but it does not expect a small increase to cause a major disruption to the recovery. If higher interest rates are a function of the Federal Reserve Board’s response to an improving economy in 2014, the increased borrowing cost will be offset by greater demand and therefore higher rents. However, the report cautions that if rates rise faster than anticipated—or faster than the underlying economic improvement—the real estate recovery could be undermined.

A significant example of the shift by investors from some core markets and into other markets is seen in the findings for Washington, D.C., a longtime favorite for investment and development due to the economic stability provided by its close association with the federal government. Ranked number one as recently as 2011, Washington slipped from eighth place in the 2013 report to 21st in the 2014 investment rankings, positioning it close to the middle of the 50 markets ranked. “Fed [federal government] fatigue” appears to be diminishing the investment appeal of the nation’s capital, the report notes, and what was once viewed as an asset—the influence of the federal government—is now seen as a liability, with concerns caused by the federal shutdown and the ongoing uncertainty surrounding federal budget cuts and government spending.

A number of the markets anticipated to perform well in 2014 are benefiting from the continued influx of foreign capital. Miami, which rose to number eight in the 2014 forecast from 12th and 17th place in 2013 and 2012, respectively, is benefiting from South American investment. Its homebuilding prospects in particular are favored by respondents. Another example is Seattle, which ranked sixth in this year’s survey. The city’s global connections, high rate of educational attainment, and growth in the technology industry are making it a hub for international investment.

Emerging Trends notes that the scope for foreign investment in these markets is demonstrated by a recent survey conducted by the Association of Foreign Investors in Real Estate, which found that 71 percent of overseas investors believed that the “economic fundamentals had improved to the point that makes secondary cities in the U.S. worth looking at for new real estate acquisitions.” This is borne out by Real Capital Analytics data, which demonstrate that $22.8 billion of U.S. real estate was bought by foreign investors between January and August 2013, accounting for 13 percent of all real estate transactions in the United States.

The top five ranked markets in the 2014 report are as follows:

1. San Francisco. The top-ranked market in the survey for the second year in a row, San Francisco has a real estate sector driven by a thriving economy that is projected to add jobs at a rate of 2 percent next year. According to survey respondents, the city is a solid “buy” for all property types, with each of these recommendations higher than the average for the other major markets. Respondents are particularly confident about the prospects for San Francisco’s hotel sector.

2. Houston. Investment and homebuilding prospects boost Houston from its number-five position in last year’s survey. Housing, nonresidential construction, and a revival in exploration industries will be the key economic drivers in 2014. Employment gains are projected to come from related manufacturing and professional services, as large companies relocate more of their headquarters operations to Houston. Over the longer term, above-average population growth and expansion in energy, health-related, and distribution industries will help propel above-average economic growth.

3. San Jose. The third-ranked market for the second year in a row, San Jose draws investors with the prospects offered by its technology industry. Respondents believe that the job and income growth generated by the sector will support rising real estate demand. The breadth of San Jose’s economic growth should broaden in 2014. Longer term, the San Jose economy will continue to benefit from the cluster of leading tech firms, its ability to cultivate and attract innovative companies, and the city’s highly educated population.

4. New York City. Slipping two places to number four in this year’s survey, New York City has investment and development components that are still rated as “good.” However, concern is growing that pricing is again becoming too high. New York is on the verge of a self-sustaining expansion: employment has surpassed its prior peak well ahead of other large metropolitan areas, and U.S. job growth in 2014 will get more support from goods industries as construction hiring ramps up. Finance layoffs will abate midyear, paving the way for stronger growth. Rental apartments and hotels are the property sectors that respondents feel offer the best opportunities in 2014.

5. Dallas/Fort Worth. Rising four spots to number five in the 2014 survey, Dallas/Fort Worth was rated highly for investment and development. It was its strong homebuilding prospects, however, that moved the market up in this year’s survey. Industrial/distribution is the property type that survey respondents most recommend as a “buy” in this year’s survey. Apartment, retail, and office all have “buy” recommendations above the comparative average, but respondents feel that it would be better to sell Dallas/Fort Worth hotels in 2014.

Industry Sectors

In terms of market sector prospects, industrial real estate tops the ranking in this year’s report, with warehousing standing out as a particularly strong subsector. Warehousing was a clear favorite among the survey’s respondents, with 64 percent making a “buy” recommendation for the subsector and under 10 percent advising selling. With retailers and manufacturers continuing to shorten their supply chains, the ongoing growth in e-commerce—especially in same-day or next-day delivery—is fueling the requirement for vast fulfillment centers close to major cities. Research and development industrial, self-storage, and data centers also are expected to show further improvement.

Multifamily housing, which has been the most popular sector in recent reports, is still popular with investors, as the underlying fundamentals remain intact due to demand from members of generation Y (also known as the millennials) seeking to rent and baby boomers looking to downsize from houses to apartments.

Now in its 35th year, Emerging Trends in Real Estate® is one of the most highly regarded annual industry outlooks for the real estate and land use industry. It includes interviews with and survey responses from more than 1,000 leading real estate experts, including investors, fund managers, developers, property companies, lenders, brokers, advisers, and consultants. The report was released at the 2013 ULI Fall Meeting in Chicago during November. Full copies are available at uli.org.