For the past two years, the apartment transaction market has been very black and white—it seemed like either everybody wanted an asset, or nobody did.
The best properties saw furious bidding wars, as a flight to quality among institutions intensified. And anything in a lower asset class, or far off from the major metros, was met with a somewhat lukewarm reaction.
But the cap rate disparity between primary and secondary markets is beginning to flatten, a trend that’s likely to grow in 2012.
Investors are increasingly balking at the pricetags on Class A assets in the nation’s largest markets, taking a step back and re-assessing their options. The cap rate compression found in the cream of the crop is finally halting, and even beginning to turn the other way.
“Everybody wants to be in the gateway cities and Class A product, and they’ve driven the yields so far down that there’s been a rebound effect,” says Gary Mozer, principal and managing director of Los Angeles-based investment banking firm George Smith Partners. “Stuff was selling in Los Angeles at a 4.5 percent cap, and now it’s a 5 percent cap again.”
The risk premium in the multifamily industry remains healthy—the spread between the 10-year Treasury and cap rates is as wide as it’s ever been. But investors are increasingly questioning the elasticity of demand for Class A product, and finding better yielding opportunities in lower asset classes, and smaller markets, with less perceived risk.
“I don’t think cap rates are going to compress much more in the core, A-quality assets. We’re starting to see a little pushback—there’s caution in the wind, and that’s probably appropriate,” says Bill Hughes, managing director of Encino, Calif.-based Marcus & Millichap Capital Corp. “Where you could continue to see some cap rate compression is on some lesser quality assets in smaller markets.”
Part of the equation is a sense that today’s environment is a brief window of opportunity. While the cost of capital is historically low now, investors looking to hold for five years have to consider the very real possibility that, when it comes time to refinance, interest rates may be up by 200 basis points or more, which changes the equation.
“We’re seeing greater interest in value-add deals and deals in secondary markets,” Hughes says. “More investors are looking at the difference between a cap rate in a core asset in a major metro versus a B-quality asset or a B-plus asset in a smaller market, and are seeing more opportunity there.”
Mozer has also seen much more activity in secondary and tertiary markets. For instance, his company recently arranged some capital for a deal in a tertiary market in Washington state, where a large local employer had gone on a hiring spree. For a long time, financiers only wanted the safest bets, but debt and equity providers are starting to listen again to “story” deals.
“Six months ago, I couldn’t get equity or debt to look into Atlanta, the B and C marketplaces,” Mozer says. “We’re now finding debt and equity to go there, because the yields are ridiculous. We’re dong deals in Santa Rosa, in Phoenix—the story still has to be compelling, but people are willing to look at the story deals, which they haven’t done in years.”