Nadji: Velocity will shift to secondary and tertiary markets.

CALABASAS, CA-As the economy finds its way to steadier ground, multifamily investors will pay more attention to the value add segment. That’s one of the key conclusions to be drawn from Marcus & Millichap Real Estate Investment Services‘ newly issued 2014 National Apartment Report, prepared by the firm’s Hessam Nadji, SVP and chief strategy officer; and John Chang, first VP of research services.

With that increased demand for class B and C properties—driven by investor interest in greater yield and price arbitrage compared to class A assets—will come lower cap rates, the report predicts. “Transaction velocity by necessity will shift to secondary and tertiary markets, and investors must weigh the incremental value of additional yield relative to higher risk,” write Nadji and Chang. Putting a crimp on this appetite, however, is the fact that sellers have been slow to bring properties to market, “thereby limiting the number of opportunities.”

Looking ahead into the new year, there will be plenty of capital to finance new construction, the report states. “Equity for new development waned briefly as rising construction costs and oversupply conditions mounted,” Nadji and Chang write. “However, equity and hedge funds returned as newly delivered units leased quickly.” Although supply and demand appear to be on an even keel throughout the year, Nadji and Chang sound a note of caution on whether demand supports “the magnitude of the development pipeline that could potentially be funded.”

Conversely, though, Nadji and MMI president and CEO John Kerin point out in a foreword to the report that “the return to a normal credit environment does suggest incremental increases in financing rates going forward.” Yet the good news for investors here is that NOI growth, cap rate spreads and lender spreads all provide “a healthy buffer against future bond yield increases.”

More importantly, Nadji and Kerin write, “further increases in interest rates will likely reflect strengthened job creation and economic momentum rather than Fed policy speculation.” In addition, “a low-inflation environment with greater political certainty and less fiscal tightening” will prevail this year.

Meanwhile, they predict that domestic and cross-border investors alike “will fuel capital allocations to US real estate assets compelled by the need for safety, a strong income return and yield compared with alternative investments.” Accordingly, this competition will exert downward pressure on cap rates.

While new supply thus far in the recovery has been “well-matched by rising renter demand,” the report notes that the number of new units delivered in 2013 increased 84% over the prior year to 168,000. “Another 215,000 units in ‘14 will surpass demand for 176,000 units, increasing vacancy by 20 basis points to 5.1%,” according to MMI’s report.

Secondary markets that have been later to the recovery party, along with mid- to lower-tier assets, led revenue gains, resulting in 4.2% growth in effective rents last year. “Despite a rapid lease-up in new units, class A assets will bear the brunt of competition from new supply, paring effective rent growth overall to 2.6%,” the report states.