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.”

Are Multifamily Cap Rates Too Low?

Multifamily Executive has an interesting piece that asks the question, “Are multifamily cap rates too low?”  In short the answer is it’s all relative:

Investors grumble that high-barrier-to-entry coastal markets such as Los Angeles, Washington, D.C., and New York, where cap rates can sit in the 4 percent range, have grown much too frothy. At sub-5 percent cap rates, the math an investor needs to make that investment a long-term win is pretty aggressive in terms of NOI growth.

Yet the multifamily sector continues to benefit from a lack of viable investment alternatives. The stock market continues its schizophrenic pace, and 10-year Treasury bonds are yielding around 2 percent. In short, where else can investors put their money to achieve the same kind of stable returns?..

But it’s a delicate balancing act, a window of opportunity. Capital is still looking for a home because other markets haven’t yet recovered. Multifamily owners certainly hope the job market recovers quickly, since it’s the primary driver of fundamentals. Yet, if you’re still looking for capital, or looking to sell, you may not want the broader economy to recover too quickly.

“We need job growth, but the other end of the sword is, when jobs increase, you might see inflation, interest rate movement, and less people interested in buying apartments because there are other options,” Ravin says. “If you’re just starting to build or are looking for capital, you’re sort of hoping that the capital remains in multifamily long enough for you to capture it.”