Two years ago, the real estate investment market was completely shut down. Nobody expected to see pre-recessionary cap rates again for many years. Over the next year, capital started to flow into the sector, hoping to capitalize on the market’s distress. However, the anticipated level of distress never materialized and investors needed to adjust their return expectations. As financing became available, underwriting standards loosened, and interest rates came down, more capital flowed into the real estate sector. The fundamentals side of the market, however, has been moving considerably slower, focusing investors and lenders on Class A product in Class A locations. The accompanying chart segments markets into three tiers: Tier 1 consists of the nation’s top five investment markets, Los Angeles, Chicago, New Jersey, Atlanta and Dallas; Tier 2 includes the next 11, mostly primary markets, such as Houston, Miami and Seattle; Tier 3 covers 15 secondary markets, such as Denver, Minneapolis and Ohio. While cap rates in Tier 1 markets are already back to their pre-recessionary levels, Tier 2 markets still have about 50 basis points to decline, and Tier 3 markets remain 100 to 150 basis points above their peaks.

The two primary drivers of this aggressive decline in cap rates are the low cost of capital and rent growth expectations. Today, a private REIT that is paying a 6.5-percent dividend yield can offer sub 6-percent cap rates and still cover its cost of capital. Stronger rent growth that will follow the unprecedented declines of the last two years can elevate 6-percent cap rates to double-digit unleveraged IRRs. However, cap rates in Tier 1 markets are approaching the floor and the increasing spread over Tier 2 and 3 markets is becoming very attractive. Expect this spread to narrow by the end of 2011.

Source: RCA, Grubb & Ellis