Secondary Markets and Cap Rate Compression

Secondary markets sometimes experience cap rate compression that creates massive equity gains for early investors.

This is one of the most powerful tailwinds in private real estate. It is also one of the least predictable.

What Cap Rate Compression Is

Cap rate compression is when buyers accept lower yields for the same asset. A market that previously traded at 7 percent caps starts trading at 6 percent caps.

On a 200 thousand dollar NOI property, that compression alone increases value from 2.86 million to 3.33 million. A 470 thousand dollar equity gain with no operational changes.

What Drives Compression

Capital inflows. When institutional capital starts targeting a market, more dollars chase fewer assets and prices rise.

Cycle dynamics. When primary markets become too expensive, capital migrates to secondary markets, compressing those caps.

Demographic shifts. Markets gaining population and jobs attract investment. The investment compresses caps.

Interest rate moves. When debt costs fall, cap rates often compress because the spread to debt stays roughly constant.

Secondary Market Examples

Boise compressed from mid 6 percent caps to low 5 percent caps between 2018 and 2021. A massive run that rewarded early investors.

Indianapolis compressed similarly. Columbus. Kansas City. Des Moines. All saw secondary market compression as capital fled overpriced coastal markets.

Then the compression reversed in 2022 and 2023 as rates spiked. Markets that had compressed expanded back out.

Why This Matters Now

Many Midwest secondary markets are still trading at cap rates that have decompressed in the last 24 months. Compared to where they traded in 2021, they are 100 to 150 basis points wider.

If rates stabilize and capital normalizes, some of that compression will return. Investors who buy now at the wider caps benefit from the eventual recompression.

This is not guaranteed. It is a thesis. But it is a thesis backed by historical pattern.

How to Position

Buy quality assets in growing secondary markets at today's wider caps. Operate them well. Let the value-add execution drive NOI.

If compression comes, you get the dual benefit of NOI growth and cap compression. If it does not come, you still made money on operating performance.

Asymmetric. Limited downside. Significant upside if the thesis plays out.

The Risk

Cap rate compression can reverse. The 2008 cycle saw caps expand 200 plus basis points in some markets in 18 months.

Underwriting cannot rely on compression. It has to work without it. The compression is upside, not the thesis.

Sponsors who underwrite cap compression as the primary return driver are speculating. Sponsors who underwrite without it and treat compression as bonus are investing.

This example reflects a specific historical period of cap rate compression that is not guaranteed to repeat and should not be treated as a projected return.

Related Reading

Why Midwest Multifamily Outperforms Coastal Markets

How We Underwrite Rent Growth Without Gambling on the Market

What a Preferred Equity Position Means in the Capital Stack

Market Rent vs Contract Rent: The Upside Operators Underwrite