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Have Cap Rates on Multifamily Properties gone Completely Nuts?

September 6, 2022

Multifamily cap rates at an all time high

By Terry Painter/President, Apartment Loan Store – Author of “The Encyclopedia of Commercial Real Estate Advice”. 

 

I have worked as a commercial mortgage banker for the past 25 years and have encountered many surprises. But nothing that equals the call I got last week from a client that was making an offer on a 36-unit, C Class property in Greenville, South Carolina. “Are you seriously going to buy this property at a 3.76 cap?”, I asked him.

 

The seller had owned the property for 16 years and had hardly raised rents in this blue-collar neighborhood during that time. But really? A 3.76 cap? Earlier this year I closed a multifamily loan on a B class property in Santa Monica, California at a 3.25 cap which made perfect sense in that neck of the woods.  

 

Have cap rates on multifamily properties gone completely nuts? How is it that a C class property in a working-class neighborhood in South Carolina can be offered at close to the same cap rate as a B class property in one of the most moneyed areas of California?  And why was my client willing to pay such a high price for a property that did not have the net operating income to support it? Stay tuned. I will get to that in a moment. 

 

Why Cap Rate Compression today is almost Scandalous 

Historically, cap rate compression (the lowering of cap rates) occurs naturally because of rents going up over time creating more net operating income and higher property values.This is often accelerated by a process called forced appreciation when rents are pushed up by cleaver investors that implement value adds. But what’s happening now is an anomaly due to the four factors in play below. What seems almost scandalous are the high number of sellers that haven’t bothered to upgrade their properties or increase rents that are being rewarded with insanely high sales prices for doing absolutely nothing but being at the right place at the right time. 

 

4 Reasons Cap Rates on Apartment Buildings Have Been Compressing

1. Low Interest Rates – Cap rates have been coming down on apartment buildings pushing values up at a rapid rate since the recovery phase of the great recession in 2010, and even more so during the corona virus recession of 2020. During both recessions the Feds purchased an unprecedented amount of treasury and mortgage-backed security bonds that kept long term interest rates artificially low.  These record low rates supported a much higher loan amount which made it feasible for buyers to get financing at a much higher sales price. 

 

2. Supply and Demand – Just as in the housing market, the corona virus created a record low inventory of multifamily properties for sale as buyers and sellers insulated themselves from each other. Once it was safer for people to mingle again, many sellers were reluctant to put their properties on the market, thinking prices would go up even higher.

 

3. Low Construction Starts – in March of 2020, the corona virus pandemic scared most lenders from making construction loans on projects already in the works.   About 6 months later these lenders were eager to lend again. But by then, the supply chain calamity increased the cost of materials and labor making it economically prohibitive to build. Fortunately, the cost of materials is coming down now, but labor is still at an all-time high. To add insult to injury the feds raised prime rate (which most construction loans are based) 2.25% between March and July 2022. This lowered loan amounts and increased construction cost.  

 

4. Record High Rents and Low Vacancies – With the cost of homes skyrocketing, more Gen Z first time home buyers were sidelined into the rental market, pushing rents up by over 10% in 2021 and over 15% annually through June of 22 according to Redfin.  According to Moody Analytics, multifamily vacancies hit a 20 year low of 4% in the second quarter of 2022.

 

So, now getting back to why my client was so eager to overpay for the property mentioned earlier. He’s actually a smart guy who owns an apartment building down the street that is full with a waiting list. The property he wants to buy is in good condition with under market rents. All he has to do is raise the rents 60% to market rate and he will hit a home run. 

 

Will Multifamily Prices be Coming Down Soon?

It seems evident that multifamily sales prices have reached their peak. Sales for multifamily properties started dropping in May 2022 due to increased interest rates according to the National Multifamily Housing Council. Another telling factor is that  multifamily starts (5 Units +) increased by 18% year to date through June in 2022 according to the National Association of Home Builders and will add 300,000 new units to the market in 2022 according to CBRE.  

 

With historically high inflation, rising interest rates, and the gross domestic product (GDP) being down for two consecutive quarters, a recession could be looming around the corner. If this happens will prices come down? Not likely. Unlike the great recession where vacancies and delinquency on rent payments dangerously increased due to high unemployment, the opposite is the case now. And most sellers today have savings plus good incomes and can afford to wait to get the prices they want. With or without a recession, it’s more likely prices will flatten for quite a long time, with demand for units remaining high. And with the stock market being a roller coaster ride, more investors will view the high prices of multifamily real estate as a safe haven.