The market for equity looking to invest in multifamily remains strong, but a flight to quality has widened the gap between primary and secondary markets.

Many equity investors began venturing away from the largest metros as the year began, looking for yield in sometimes unexpected places. But there’s been a shift in investment philosophy since the capital markets volatility seen over the summer, culminating in S&P’s downgrade of U.S. debt.

“The number of investors that are interested hasn’t change, but the emphasis has changed slightly,” said Dan McNulty, co-chairman and co-CEO of New York-based Rockwood Real Estate Advisors, one of the panelists on the "Money, Money, Money: Navigating the Current Spectrum of Equity Sources" session at the 2011 Multifamily Executive Conference. “We’ve seen a little bit of a retreat from the yield chase, back to markets where they have certainty of quality.”

This flight to quality, and the resulting cap rate compression in major markets, has led many investors to move away from acquisitions and target new development in strong urban locations. “There’s going to continue to be a strong market for multifamily; it’s the one product that continues to have the most equity activity,” McNulty said. “A majority of what investors are pursuing is development projects, because they figure that they’re better off to develop to a 6 cap than buy at a 4 cap.”

But that dynamic can only last so long. Robert Hart, president and CEO of Beverly Hills, Calif.-based Kennedy Wilson Multifamily, said that finding equity for deals in markets sucha s Petaluma, Calif., or Tacoma, Wash., remains a challenge. As yields continue to shrink in cities such as San Jose and Seattle, investors will again look elsewhere for desired returns.

“There is a flight to infill, to more 'riskless' returns,” Hart said. “But we will see the quality bar move outward slightly—that pendulum will be shifting as there are fewer and fewer deals in those locations.”

And as smaller investors get muscled out of the largest markets, they’re increasingly and creatively finding deals around the perimeter. “It’s very difficult to compete with the institutions. But outside of Manhattan, there are plenty of opportunities to be found in the four other boroughs of New York,” said Dave Valger, founder of New York-based DVO Real Estate Holdings. “And places like Salt Lake City and Denver are interesting and poised for a strong recovery.”

But it takes a compelling story to lure investors into stable, but unspectacular markets—“rent growth” metros where valuations stay relatively steady. The same goes smaller deals looking for investments of less than $5 million, though a host of less identifiable providers, starting with family offices, are growing more active. “The right mortgage banker can programmatically arrange deals—one deal would be tough—but if you can do a series of deals, it starts to make more sense,” Hart said.