Secondary Markets Likely to See More Cap Rate Compression

It seems to happen at this point in every cycle: Core assets in primary markets recover first, followed by a trickle-down into secondary markets, B assets, and value-add deals.

But this year feels different. As more investors increase their risk tolerance and cast a wider net in search of yields, that trickle may be more like a flood.

“It’s happening faster this time; there’s more capital floating around at this point in the cycle than usual,” says Dan Fasulo, managing director of New York-based market research firm Real Capital Analytics. “Secondary markets are certainly picking up steam. The promise of extra returns really gets investors to venture out along the risk spectrum.”

Last year offered a brief window of opportunity to play it safe. The ultra-low yield on the 10-year Treasury produced a big spread between cap rates and interest rates. The ability to borrow at 4.25 percent covered many sins, allowed many deals to pencil out, even given a low cap rate.

“What happened in 2010 was unprecedented. It was nirvana,” says David Gardner, CFO of Rochester, N.Y.-based REIT Home Properties. “We’ve never seen that much spread between first year cap rates and debt costs. That’s why we were so gung ho in getting as much as we could.”

Home Properties, which focuses on B-quality assets in suburban markets, spent $339 million last year to acquire nine properties totaling 2,614 units. But interest rates have risen at least 100 basis points (bp) since November, and there’s much less of a margin of error now. “You didn’t have to be as perfect on the underwriting last year, but you’ve got to sharpen your pencil now because there’s a much slimmer spread,” Gardner says. “There are going to be deals that, a year ago we would’ve said ‘yes’ to, but today we’ll have to say ‘no’ to.”

Most investors feel that cap rates will stay relatively flat or rise this year due to the higher yield on the 10-year Treasury. At the same time, many institutional investors are getting tired of sitting on their equity—there continues to be a mountain of pent-up demand, and limited supply, in the transaction market.

“It’s going to be an interesting clash between the impact the higher interest rates will have versus how much capital still wants to get placed,” says Aaron Hancock, director of acquisitions for Laguna Niguel, Calif.-based Raintree Partners. “Which one of those two turns out to be more powerful is a big question mark.”

The spread between average cap rates and the average mortgage rate is still high, historically speaking. And given the desire to place capital—and the ability to once again assume some rent growth—many investors are willing to accept a lower cap rate. “It’s not unreasonable, given how historically high those spreads are, that the 10-year could rise, and cap rates could still go down,” Fasulo says. “We’re forecasting some heavy cap rate compression for secondary markets this year.”

Beyond the tightening spread, investors are bracing themselves for a more competitive transaction market this year. As more capital sources such as life insurance companies, banks and conduit lenders grow active, more bidders will be lining up.

“A year ago, even though there was a lot of pent-up demand, there was not a lot of competition. At the end of the day, how many people can just write a check?” Gardner says. “Every month that goes by, the credit markets are opening up, and it gets potentially more people competing against you. It’s going to be tougher this year.”