They can't sit on the money forever. But with the frenzied bidding wars on Class A assets in core markets having caused cap rates to quickly compress, it often doesn't make sense to buy. That leaves a mountain of pent-up capital gathering on the sidelines as equity investors sift through molehills of opportunity in stabilized, core deals.

As such, many investors are increasingly chasing yield into new development while waiting for an expected bonanza of recapitalizations. Although more are now looking to acquire outside of primary markets in search of yield, they ultimately see a safer bet in the new-development or value-add spaces. In fact, the equity side of the capital stack has come back to new development much more quickly than the debt market has.

“A lot of investors find it less risky to invest in a high-quality development deal in a core market,” says Frank Marro, managing director for multifamily investments for Norwalk, Conn.–based GE Capital Real Estate. “Traditionally risk-averse investors, ironically or anti-intuitively, see development as having less risk than investing in secondary markets or older assets."

The new-development focus of large equity investors today is mainly on infill or transitoriented development in high-barrier markets.

Consider Rockwood Real Estate Advisors, which recently worked on a multi family development deal where the equity investor was looking for total average returns in the 15 percent to 18 percent range. “Their view is, it's better to move into development, where you can build to a 6.5 percent or 7 percent cap, rather than buying something at a 4.5 percent cap,” says Dan McNulty, co-chairman and co-CEO of the New York City–based firm.

And to achieve the kind of returns they're looking for, equity investors are much more apt to back merchant developers rather than long-term holders. “You can't hit any kind of yield expectation holding it for 10 years, so most of the money ends up being a merchant-build strategy,” says John Fenoglio, senior vice president in the Houston office of Charlotte, N.C.–based Grandbridge Real Estate Capital. “There are some investors on core deals that will take a longer horizon, and they'll price that money accordingly. But unless you get some big rent growth, you're going to have to sell."

Indeed, most of the equity coming to the marketplace today is value-add money, looking for returns in the midteens or higher. The lower-return money, the core and coreplus strategies, are being rationed for true infill, true high-barrier markets.

Recap Attack

Equity providers sense a growing opportunity in the recapitalization market.

About $95 billion in multifamily debt will be maturing in the next three years, according to the Mortgage Bankers Association, and more than 40 percent of that debt, over $38 billion, will somehow need to be resized.

“At least 15 to 20 percent of new capital will have to be added to that pool of debt," estimates Dave Valger, a partner at New York City–based equity investor RCG Longview. “That's about $6 billion that has to come from somewhere."

Consider that GE Capital Real Estate is currently raising a fund called the Multifamily Recapitalization Program. As the name suggests, the program mainly targets Class A and B assets in need of being recapitalized or deleveraged. Yet, a full 25 percent of the fund will target new development in infill locations and value-add opportunities.

The focus of GE Capital's new fund is threefold: Beyond recapitalizations and new development, the program sees opportunities down the road in acquiring REO or nonperforming loans as banks and special servicers get serious about cleaning up their  balance sheets. But first and foremost, the fund will target underwater owners looking to make old deals whole again.

There will, however, be some class distinction in the types of recap deals that get done. The Class A properties shouldn't have any problem finding that capital—REITs, sovereign wealth funds, and even some debt providers will find those deals desirable. But the B and C assets will largely be on the outside looking in. “That bifurcation will create an even greater opportunity, and a better-yielding environment, for new equity to come back in,” Valger says.

Equity providers are split about whether recapitalization deals with an existing owner or an acquisition by a new owner is preferable. On one hand, equity can often find betteryielding deals off-market—when an existing owner is looking to recapitalize—rather than in a sales transaction. But on the flip side, when a title changes hands, there's generally no disagreement about value.

“If you're doing it with an existing sponsor, there's always a debate about where values are, and more time is invariably spent in that area than makes sense,” McNulty says. “So where you've got a title that you know is transferring, it's a much cleaner discussion."

Acquisition Expectations

For the acquisition of a newer-vintage construction deal in a core market, equity providers are looking to achieve a leveraged 12 percent return. “And if this is an A-plus location, you might find a capital provider that has an even lower expectation,” Fenoglio says.

For example, some infill properties in Houston are trading at 4.5 percent cap rates in all-cash deals, and the unleveraged IRR expectation is 8 percent. “People think that 4.5 will be a 6 cap in 18 months,” Fenoglio says. “Your competition for those kinds of deals is unlevered funds—they're having such a hard time putting money out, they don't want any debt."

As they grow more risk-averse, one change in the way equity investors are looking at acquisition deals is a bigger emphasis on cash flow. Investors now want 50 percent to 60 percent of their return to be achieved through cash flow as opposed to capital appreciation—in the past, 75 percent of the return would've been through appreciation.

Whether it's an acquisition, a refinancing, or new development, equity investors are focusing much more on quality of sponsorship. While sponsor scrutiny is at an all-time high, investors realize that pretty much anybody in the business had some economic hiccups throughout the downturn.

“How the person handled [himself ], what the ramifications were, and how [he is] capitalized going forward are the first things we answer on every transaction," Fenoglio says.