As for non-institutional products and tertiary markets, the trend has been one of reversal of the kind seen in early 2000’s to the peak period in 2007. During that period, cap rates in these markets steadily compressed 180 basis points (bps) to 6.8% in 2007. Almost half of that gain has already been wiped out with the cap rates increasing to 7.3% during the second quarter of 2010. However, the cap rates could easily be even higher since only the assets which have sold, or rather forced to be sold, have traded during that time.

The cap rate spreads between these two markets are mirrored on the spreads between the average cap rates for all apartment transactions and the 10-year treasury yields, directly reflecting the risk appetite for investors.

Interestingly, the risk premiums seem to hold steady when comparing mid/ high-rise apartments in urban locations to apartments in garden-type units in the suburbs. Per RCA, the spreads on the cap rates have held steadily around 100 bps all the way from 2001 to the first quarter of 2010, implying the changes in expectations on returns, but not on the risks involved.

As more institutional products are expected to hit the market during the latter part of 2010, it would be interesting to observe whether that will push the cap rates higher. Additionally, it would be interesting to observe if that will contribute to even higher or lower spreads compared to products in the tertiary markets.

If the current trend of cap rate compression for institutional products continues, then like in 2006, the yield chasers may have to migrate to tertiary markets. However, if the expected flood of assets hits the market, then cap rates might go back up even in primary and secondary markets. That could pull the “yield chasers” away from tertiary markets, reducing demand there and putting further pressure on cap rate increases there. This could potentially move cap rates towards the 7.5-8.0% range. This range could be pushed even higher if the agencies adjust their spreads for each market, essentially requiring bigger spreads in tertiary markets.

Complicating the matter further is the worsening market for single family homes, and the renewed possibility of a double-dip recession.

About the Author
Karsang Sherpa is a senior vice president at Caldera Asset Management, a turnaround management and restructuring consulting firm specializing in multifamily assets. Caldera’s team has experience working with lenders, equity investors, lawyers and other consultants to solve complex problems associated with distressed multifamily assets including turnaround, refinancing, stabilization, restructuring, dispositions and property management. For more about Caldera, please visit www.calderaassetmanagement.com