Home > Market Updates, multifamily, Uncategorized > Are Multifamily Cap Rates Too Low? It’s All Relative.

Are Multifamily Cap Rates Too Low? It’s All Relative.

December 30, 2011 Leave a comment Go to comments

The swift pace of cap rate compression over the past year continues to frustrate investors and delight sellers.

The rapid increase in rent growth and values in many markets—combined with historically low mortgage rates—has inspired more listings, as well as bidding wars.

Investors grumble that high-barrier-to-entry coastal markets such as Los Angeles, Washington, D.C., and New York, where cap rates can sit in the 4 percent range, have grown much too frothy. At sub-5 percent cap rates, the math an investor needs to make that investment a long-term win is pretty aggressive in terms of NOI growth.

Yet the multifamily sector continues to benefit from a lack of viable investment alternatives. The stock market continues its schizophrenic pace, and 10-year Treasury bonds are yielding around 2 percent. In short, where else can investors put their money to achieve the same kind of stable returns?

“A lot of investors will justify it by saying, ‘If I can get a 4.5 percent return today, relative to my money market account or Treasuries, then I’ll take the premium,’” says Ryan Krauch, a principal at Los Angeles-based lender Mesa West Capital. “But the problem is your long-term exit capability—you really have to be a long-term holder, or very optimistic on rent growth.”

The projected rent and occupancy growth over the next couple of years not only provides stability but also a way out for many investors. Investors sitting on large sums of capital need to put money out, after all. And multifamily is a great place to park some capital for a few years and wait for other investment sectors to bounce back.

“Is it getting overheated? You can make the argument, but there are very few places to put institutional money right now,” says Mark Beisler, chairman and CEO of Columbus, Ohio-based lender Red Capital. “People are willing to accept a much lower return for quality apartments in high-demand areas, just to get the money out.”

And the investment climate today is very different from the height of the last boom market, especially in some very key metrics. When the apartment transaction market was at its frothiest in late 2006 and early 2007, the spread between the average multifamily cap rate and the 10-year Treasury rate slimmed to just 90 basis points (bps). Today, with the yield on the 10-year Treasury around 2 percent, and the average cap rate above 6, that spread is well over 400 bps. 

“If the technology sector or energy sector or something else comes roaring back and looks relatively stable, I can almost assure you that multifamily cap rates will start to rise as the world recovers,” says David Ravin, president and CEO of Charlotte, N.C.-based developer Northwood Ravin. “But for now, a lot of people are going into real estate feeling it’s near bottom, and the returns in multifamily aren’t going to get any worse, so they can justify that return.”

But it’s a delicate balancing act, a window of opportunity. Capital is still looking for a home because other markets haven’t yet recovered. Multifamily owners certainly hope the job market recovers quickly, since it’s the primary driver of fundamentals. Yet, if you’re still looking for capital, or looking to sell, you may not want the broader economy to recover too quickly.

“We need job growth, but the other end of the sword is, when jobs increase, you might see inflation, interest rate movement, and less people interested in buying apartments because there are other options,” Ravin says. “If you’re just starting to build or are looking for capital, you’re sort of hoping that the capital remains in multifamily long enough for you to capture it.”

Reprint from the MultifamilyExecutive.com          By Jerry Ascierto

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