New York; Boston; Washington, D.C.; the Bay Area; Southern California; and Seattle.

They're called the “sexy six,” and they roused the multifamily industry out of the recession. Investor interest in those core markets has been intense since mid-2009, leading to rabid bidding wars and ever-higher price tags.

But in some ways, the sexy six may have run their collective course. Capitalization rates have gone so low in those areas—declining to and, in some cases, going below their pre-recession lows—that a growing number of investors are searching for yield in less celebrated cities.

“If all the money flows into the sexy six, either not everyone will get fed, or people will get fed but won't like the meal,” says Mike Kavanau, senior managing director in the Chicago office of Holliday Fenoglio Fowler. “At the end of last year, we saw cap rates back up a little in the core markets—you can only go so low on cap rates before people start expanding their horizons and look at secondary markets.”

Consider Behringer Harvard. Throughout the recession, the Addison, Texas–based company was one of the industry's most active and aggressive acquirers, a beacon of opportunistic investment. In 2010, the company spent an astounding $855 million on apartment buys, second only to industry titan Equity Residential.

But last year, Behringer Harvard wasn't even among the 10 most active buyers. “Cap rates have compressed to a level where you have to be very selective and maybe look at alternative locations to meet your return expectations,” says Mark Alfieri, executive vice president and chief operating officer for Behringer Harvard Multifamily REIT 1. “We're very deliberate about our investment style, and with cap rates compressing, we've deployed capital in other areas.”

Like many multifamily investors, Behringer Harvard sees better yields in development these days. The company recently broke ground on its first in-house development project, not far from its headquarters. Behringer Harvard has also closed on a few land sites in Austin, Texas; Atlanta; and Costa Mesa, Calif., and intends to break ground in those markets in the next 12 months.

Financiers have also followed this trend. Life insurance company Northwestern Mutual has always focused its commercial real estate lending efforts on apartments—about 27 percent of its loan portfolio is multifamily, as is about 31 percent of its equity portfolio.

The life company had one of its biggest years in 2011, lending $4.5 billion to commercial real estate deals, $1.1 billion of which was in multifamily. Northwestern Mutual lent another $700 million to apartment developers last year by pairing a debt execution with its equity program—bringing its multifamily debt volume up closer to $1.8 billion.

But like many financiers, Northwestern Mutual knows it has to get creative to continue growing its book of business.

“We've already penetrated enough into the big markets and big deals, and so suddenly we've got to find some new tricks to expand our market share,” says David Clark, a vice president of Milwaukee-based Northwestern Mutual. “If you're going to go into secondary and even tertiary markets, the sector you want to do it in is apartments. It could be that we just need to beat the bushes to find more deals.”

Hottest Secondary Markets

The institutional investors that made the sexy six a bellwether for the industry are now setting their sights on the second tier. And the trickle-down of capital is well under way—markets like Denver; Portland, Ore.; Dallas; and Houston have captured increasing inflows of investment over the past 18 months, a “sexy secondary four.”

In fact, Denver saw a 170 percent increase in apartment transaction volume last year, while Portland's deal volume climbed 61 percent. And Dallas and Houston saw increases of 41 percent and 27 percent, respectively, last year, according to Real Capital Analytics.

“It was really in the second half of 2011 when we saw the movement of institutional capital into secondary markets,” says Hessam Nadji, managing director of research for Encino, Calif.–based Marcus & Millichap. “It's still relatively fresh in the cycle.”

The proof is in the pudding. The markets that saw the biggest uptick in apartment values last year include Austin, Texas; Raleigh–Durham, N.C.; Nashville, Tenn.; Palm Beach, Fla.; Columbus, Ohio; and Detroit. This is hardly the sexy six, but these markets have outperformed the nation's top markets in some key metrics.

Austin saw the most dramatic improvement last year in apartment values. The capital city of Texas led the nation last year in price appreciation, with a 42 percent rise in price per unit over the year before, reaching nearly $107,000. Cap rates fell about 160 basis points (bps) in Austin last year and are now averaging about 5.8 percent—putting it on par with markets like Los Angeles and San Diego—according to New York–based market research firm Real Capital Analytics (RCA).

Along with Austin, Raleigh–Durham has popped up on a lot of radars over the past year thanks to a concentration of technology-focused jobs and a young, well-educated workforce. Last year, the market saw a 21 percent appreciation in pricing, reaching $99,589 per unit, and cap rates compressed about 60 bps year over year, according to RCA.

Nashville, Tenn., has also risen in the ranks—average price per unit jumped 18 percent last year, to $77,262, and cap rates compressed by 110 bps. Another standout was Palm Beach, Fla., which saw its average price per unit rise 18 percent as well, to nearly $183,000, while cap rates compressed an astounding 160 bps last year.

In terms of cap-rate compression, Detroit led the pack nationally, with average cap rates falling 300 bps year over year. But the Motor City was starting in a pretty tough place to begin with—cap rates there averaged nearly 11 percent in 2010.

Still, of the top 10 markets with the most cap-rate compression last year, half of them were from the Midwest. Following Detroit were Kansas City, Mo.; Minneapolis; Cincinnati; and Cleveland, which all saw at least 100 bps of cap-rate compression in 2011.

“What we see in those Midwest markets right now is that they are performing about in line with the national norm, which is good for them, because they tend to underperform compared to the country as a whole,” says Greg Willett, vice president of research and analytics for Carrollton, Texas–based MPF Research. “There is some economic momentum across the region as a whole.”

Willett cites the submarkets of Detroit as particularly strong, as does Marcus & Millichap's Nadji, who notes that Detroit's metro-wide vacancies are just around 5.5 percent these days.

Attracting Capital

At the end of 2011, the nation's tightest markets didn't include any of the sexy six. In fact, that list was probably more slanted to tertiary markets than anything. The nation's top five leaders, all exhibiting occupancies of more than 97.8 percent, were Madison, Wis.; Fort Collins, Colo.; Midland/Odessa, Texas; Syracuse, N.Y.; and Pittsburgh, according to MPF Research. But that doesn't mean that tertiary markets like Midland/Odessa—which, by the way, had rent growth of 16 percent last year—are getting their share of investor interest just yet.

The trickle-down is only starting to be felt in secondary markets, and it will take awhile before the trend reaches down farther. Cap rates in tertiary markets have remained between 7.50 percent and 7.75 percent for almost two years, according to RCA.

But apartment owners across the country are having an easier time attracting capital. Even if you're in a Fannie Mae pre-review market like Detroit, there's always Freddie Mac, which tends to take a more deal-centric approach. And as banks increase their shorter-term business, and life companies expand their credit boxes a bit, borrowers in secondary markets have more options than they did a year ago.

“Lenders are still going to be very cautious in the worst submarket of Detroit or L.A.,” says Nadji. “But as far as getting an audience with a lender, telling your story about what you want to buy, and finance, the door is wide open.”

This is certainly true for permanent debt, but access to rehab or new construction debt has proven to be much more difficult in any market, doubly so in the nation's less well-populated metros. So while the country's secondary markets are seeing more acquisition volume, the flow of new supply should continue to be constrained as banks remain cautious.

“The biggest governor on new apartment development is the availability of construction lending,” says Kavanau. “Equity really wants to achieve yield and probably will be a little undisciplined to find it. But the construction loan market is still highly disciplined—it won't chase a deal just for yield.”

A Risk Premium Mirage?

One of the key metrics that multifamily investors consider before pulling the trigger on a deal may not be what it appears.

The spread between the yield on the 10-year Treasury and a given capitalization rate is often referred to as the “risk premium”—and the wider that spread, the better. In the frothiest days of the last boom period, in late 2006, that spread averaged around 90 basis points (bps), a razor-thin margin.

With the 10-year Treasury still around 2 percent, and the average cap rate around 6.5 percent, today's average risk premium is a healthy 460 bps. But given the Treasury Department's concerted effort to keep interest rates low, can today's risk premium be trusted?

“We're in a world with artificially low interest rates—and the question is, are cap rates also artificially deflated?” says Mike Kavanau, senior managing director in the Chicago office of Holliday Fenoglio Fowler. “That relationship between cap rates and Treasuries is not as valid an indicator as it was for the last 50 years.”

Fundamentals also come into play in a big way when penciling out a core deal—many investors are hanging their hat on aggressive rent growth. But rosy forecasts of rent growth also must be taken with a grain of salt. Sure, the apartment industry has demographics on its side, but how much can rents be pushed over the next five years?

“That's the bad news: Will the rent growth be there?” asks Hessam Nadji, managing director of research at Encino, Calif.–based Marcus & Millichap. “If you look at wage growth for renter households versus the kind of rent growth that some of this modeling requires, you wonder if the wage growth really supports it.”

There's also a widely held assumption in the multifamily industry in “renter nation,” the belief that there's been a paradigm shift in this country, that homeownership isn't as desirable as it once was. For the immediate term, that's true—it's harder to qualify for a mortgage than it was six years ago.

But is the falling homeownership rate really a structural shift, or is it cyclical? In a couple of years, interest rates may still be low, and job growth might come back in earnest.

“At some point, maybe in 2013 or 2014, there's going to be a wave or two of renters buying homes and condos again,” says Nadji. “That's another threat to the logic that we're going to see tremendous rent growth.”

The risk premium is just one way of looking at a transaction. An unleveraged internal rate of return is a primary metric for many investors, and a movement in interest rates doesn't impact that as much. And if a buyer is underwriting a deal based on the availability of a 10-year loan priced at 4 percent—and then interest rates move suddenly—they can do a little “duration migration,” and move to a seven-year deal with a lower rate to make the assumption work.

But in terms of fundamentals like rent growth, and demographic considerations like the flight to homeownership, a word of caution is in order. And for the many investors using today's low yield on Treasury bonds to justify a purchase, you might want to look for a different baseline.

Top Picks

When asked to pick the five most promising secondary markets for multifamily investment this year, many of the sharpest industry watchers agree on the big three Texas markets—Austin, Houston, and Dallas—as well as Portland and Denver. Here are the next markets on their lists:

Hessam Nadji, managing director of research, Marcus & Millichap: Tampa, Orlando, Phoenix, Inland Empire, and Detroit. “These are all recovery markets; they've been hit very hard and are starting to add jobs and have reasons to capture capital.”

Greg Willett, vice president of research and analytics, MPF Research: Nashville, Charleston, Charlotte, Raleigh–Durham, suburbs of Detroit. “Pretty much all the markets in the Carolinas are doing well. They have healthy employment numbers, and Nashville is behaving very much the same way.”

Ben Thypin, senior market analyst, Real Capital Analytics: Raleigh–Durham, Phoenix, Seattle, San Jose. “Institutions are now venturing into those secondary markets in search of yield.”

Mike Kavanau, senior managing director, HFF: Minneapolis, Salt Lake City, St. Louis, Kansas City, Oklahoma City. “I asked Freddie Mac the same question recently, and these were a few markets where they have very strong portfolios—what they deem as markets people should consider.”

AFT's Picks: Based on job growth projections, supply and demand figures, demographics, and recent gains in value, here are Apartment Finance Today's picks for top secondary markets: Austin, Portland, Denver, Raleigh–Durham, Nashville, Palm Beach, Columbus, Minneapolis, Philadelphia, Houston.