Cap Rate Disparity Between Primary, Secondary Markets Shrinks

The cap rate spreads between major metros and smaller cities are shrinking:

“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.”