Understanding Post-Pandemic Apartment Cap Rates
Reporters and analysts often refer to the average “cap rate” or “cap” for a type of property in a given market. For example, they might say, “Class A multifamily in the Denver CBD is trading at a 4-cap”. Translated from broker speak, this means that all of the newer apartment buildings with modern amenities, in the central business district of Denver, that sold recently, were purchased at an average price for which the projected 12 months of net operating income (“NOI”) (without factoring loan servicing, depreciation or taxes) of each property was 4% of said price.
The translation is a mouthful—jargon is clearly more economical. In mathematical terms, we can define capitalization (“cap”) rates like this:
Average Cap Rate = 12-mo. NOI / Purchase Price
for all recent transactions of a specific property type and location
Another way of expressing cap rates is to say, “For a given property type in a particular area, investors expect to receive a specific stream of income.” Cap rates can be described locally or nationally, for different sectors of real estate and for different classes.
Much like the yields of other financial instruments, fluctuations in cap rates over time and geography are primarily a function of:
- Interest rate changes
- Relative availability of investment capital
- Varying perceived risks associated with each property type
With the exception of 2008-2010, we have enjoyed a long decline in national average apartment cap rates over the last 20 years. Indeed, since 2010 the change has been a nearly linear decrease from 7.25% to 5%. All things being equal, if you bought an apartment building for $25 million in 2010 (NOI = $1,812,500) and saw no increase in income, your property in the same condition would be worth $36,250,000 today ($1,812,500 ÷ 5%), for example.
This is the power of “cap rate compression”. When interest rates decline and large investors continue to have capital to chase deals, in the absence of major risk events, cap rates will fall. In turn, this causes prices of investment properties to rise. During this century, apartments have benefited from this phenomenon more than retail, office or industrial sectors.
So, what should we expect from apartments going forward? I wish I had a crystal ball, but we do have some macroeconomic tea leaves to read.
- Interest rates changes
Cap rates do not move in lock-step with interest rates. The other two factors below explain variations in the metric known as the “yield spread” or simply the “spread”—the difference at any time between a particular cap rate and the 10-year treasury. Over the last seven years, the average national yield spread for apartments has ranged between 250 and 400 bps.1 If the treasury yield is 2.00% and a given spread is 350 bps, the resulting cap rate is 5.50%, for example.
During the last several months, we have seen spreads tighten among class-A apartments. Today a property purchased with 50% leverage may produce 50 bps lower annual cash flow than the same property acquired last year, because cap rates have held firm while interest rates have crept up. Sellers today are receiving top dollar for their properties despite an uptick in the cost of borrowing for their buyers.
Yet there comes a point when increasing interest rates must force a rise in cap rates. Theoretically, the spread between treasuries and properties should not drop to zero. Otherwise, why would you invest in real estate when you can get the same yield—with less risk—from a government bond? Of course, real estate is not just about current cash flow, but the opportunity for appreciation tomorrow must be high to ignore the risks of ownership today.
We believe it is reasonable to expect looming inflation to drive interest rates up over the next five years. Unless spreads for apartments achieve and maintain historically low levels, it is also reasonable to expect interest rates to nudge cap rates upward.
- Relative availability of investment capital
Which brings us to the second major factor influencing cap rates. On a positive note, the Federal Reserve has been pumping money into the banking system for a dozen years, with much of that capital still sitting on the sidelines. It is difficult to see why the supply/demand ratio for investing in apartment communities would swing dramatically in the near future. Moreover, the Biden tax plan could have a chilling effect on sales of appreciated real estate, thereby reducing supply and increasing the value of properties held by those willing to sell and take the tax hit.
Conversely, rapid over-building could disrupt the supply balance. Major tax law changes could alter overall investor appetite for domestic real estate. Extraordinary or sustained actions by the Fed to tighten money eventually could soften demand for income-producing real estate like apartments. After three years of apartment spreads at or below 350 bps, we may be due for an increase.
- Perceived risks associated with apartments
For a given class of apartments in a particular neighborhood, there are some key uncertainties that can drive the “risk premium” that contributes to the spread. These uncertainties may include:
- Supply risk
- Vacancy risk
- Operational expense inflation
- Taxation risk
- Regulatory risk
- Functional obsolescence
When investors feel they can forecast such uncertainties within a narrow range, the risk premium is low. On the other hand, when investors cannot comfortably quantify such risks, the uncertainty will manifest itself in higher spreads, and therefore higher cap rates. Negative economic and regulatory changes in the Bay Area last year created much higher uncertainty for apartments than, say, in Phoenix or Austin or Jacksonville. As a result, spreads in those MSAs barely moved compared to San Francisco.
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Bottom line—under the current political environment, it would be highly optimistic to believe our historically-low cap rates for apartments will remain unchanged for several years. The degree of any future increase depends on factors that are both national and local. If you suppose cap rates are likely to rise across all real estate types, then at least invest in suitable sectors that offer the chance to mitigate cap rates with potentially higher future income.
Like institutionally-operated apartments.2
For more information about passive real estate investments, please call 1031 Capital Solutions at 1-800-445-5908 or visit our website, 1031capitalsolutions.com.
 Urban Land Institute
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