Multifamily Cap Rates Continue to Expand in 2023
By Terry Painter/Mortgage Banker, Author of The Encyclopedia of Commercial Real Estate Advice, Wiley Publishers. Member of the Forbes Real Estate Council
May 18, 2023
When I first started making loans on apartment buildings nationally in 1997, it was a goldmine for investors who could put 20% down and get a 12 to 14% cash on cash return right out of the gate. Why? Because cap rates were so much higher than interest rates. It’s hard to believe but according to Freddie Mac, multifamily cap rates averaged 9.5% back then, and interest rates, 7.6%. Today that formula has been inverted with cap rates averaging 5.25% and mortgage rates over 6.00%. Now investors have to put more like 45% down to earn less than a 4% cash on cash return. Ouch!
But the good news for multifamily buyers is that cap rates are continuing to expand as we progress through 2023 according to CBRE, https://www.cbre.com/press-releases/cap-rate-expansion-likely-to-continue-but-may-peak-later-in-2023-cbre-survey-finds, going up on average of 60 bps basis points (bps) in the fourth quarter of 2022 and first quarter of 2023, and expected to continue on up at a 20 bps increase per quarter during the second and third quarters of 2023. CBRE also expects interest rates to peak later this year, which will slow down cap rate expansion.
With Such Poor Yields, Why Aren’t Multifamily Cap Rates Skyrocketing?
With such a poor return on investment for buyers at today’s prices, due to the low cap rates and high interest rate situation mentioned above, you would expect cap rates to be rising much more rapidly in 2023. But there are two main factors that are keeping this from occurring. Firstly, although it has changed to being a buyer’s market, there are just not enough multifamily properties listed for sale. The number one rule of thumb for real estate prices to drop is high inventory supply. Instead we have low supply. Why? Because most would-be sellers are waiting for interest rates to come down to list their properties, as they cannot exchange into a replacement property and get the low rates they currently have.
Secondly, most banks have made it much more difficult to qualify for a commercial loan eliminating many would be buyers. Not only are lenders stressing already high rates, but they are lowering loan to values, lowering appraised values, and increasing expenses to the max – all the weapons in their arsenal to produce smaller loan amounts and decrease risk. You can’t blame them as they fear more stringent regulations from the FEDs amid recent bank failures and the continual threat of more rate increases and recession.
To compound this problem, most properties for sale do not pencil for either the lender or borrower because of low yields. I know this firsthand, as only about one in 5 properties our firm evaluates for financing has enough net operating income to qualify. So, this is creating low buyer demand as well.
CAP Rate Forecast For 2023
UPDATED: January 5, 2023
By Terry Painter/Mortgage Banker, Author of: “The Encyclopedia of Commercial Real Estate Advice” Wiley Publishers
As a commercial mortgage banker, it hasn’t been fun in 2022 trying to juggle the most rapid interest rate hikes since 1989 with the high prices on sales contracts. As rates kept going up, our loan sizes kept going down. Many of our clients got down on their knees to plead for price reductions so we could close their loans. More often, sellers just took their properties off the market which kept cap rates low. But the worst headache was having to inform investors they needed to put 50% down instead of the 35% they were expecting. After all, most had read the real estate books that pitch buying low and leveraging high. For most, buying high and leveraging low was deeply disturbing. This meant they would likely be settling for a 2% cash on cash return after their mortgage payment.
By the third quarter of 2022, multifamily cap rates had remained flat, and there was a slight increase for industrial, office and retail according to Moody Analytics https://cre.moodysanalytics.com/insights/market-insights/the-fed-and-banks-are-putting-the-squeeze-on-multifamily-cap-rate-spreads/. The rule of thumb is that cap rates compress and push values up as a result of a strong economy evidenced by low inflation, low unemployment, a strong GDP and substantial rental increases. But it takes one more factor to really push prices up and that’s low interest rates which we had through February of 2022. Although we did have good job growth and rental increases in 2022, and GDP came in higher than expected at 2.9% in the third quarter, we had the highest inflation in 40 years combined with the most rapid increase in mortgage rates in 33 years. Cap rates should have gone up a lot more in 2022.
Going into 2023 most of the real estate investors I talk to have their brakes on. Why? Because they have absolutely no idea what properties are really worth today and they can sense they are buying at the top of the market. To add insult to injury, they know that high inflation increases operating expenses – so most are adding at least 6% on. And face it – it’s really annoying to pay today what a property may be worth in 2 years based on its current net operating income. And that’s only if you’re lucky to raise rents enough. And sellers have their brakes on too. They know that high mortgage rates mean this is not a good time to sell.
It is evident that cap rates in 2023 simply cannot go anywhere but up. Why? Because of the double whammy of high interest rates combined with the high sales prices inherited from 2021 and 2022. I didn’t think those high sales prices were supported by reality back then and I don’t think they are now. Reality being what renters can afford to pay with high inflation and the return on investment (ROI) that real estate investors expect to earn. And while we’re at it, we better include what investors can afford or are willing to put down on a loan. So, in 2023, it’s time for a reality check.
Since the third quarter of 2022, commercial real estate sales have slowed according to The National Association of Realtors https://www.nar.realtor/blogs/economists-outlook/commercial-real-estate-is-slowing-down-in-q3-2022. According to Bloomberg, prices fell 13% during that time frame. https://www.bloomberg.com/news/articles/2022-11-04/us-commercial-property-prices-slide-13-from-peak-as-rates-jump?leadSource=uverify%20wall. So there has been some movement upwards on cap rates.
I expect supply and demand to remain low in 2023 as sellers wait for rates to come down and buyers wait for prices to come down. I predict cap rates to go up by 100 bps in 2023 rising slowly at the beginning. Keep in mind as we go into this new year, most sales comparables used by appraisers to determine current values, will be from the high prices of the past 2 years which will keep cap rates low for a while. With mortgage rates expected to stay high, eventually there will be enough sellers that have to sell to bring prices down – especially if there is a recession by mid – 2023. Based on all of the above, I predict cap rates will increase by .40 bps during the first 6 months of 2023 and then go up by another 60 bps in the second half of 2023.
Where are Multifamily Apartment Cap Rates Headed
By Terry Painter/Mortgage Banker
Author of: “The Encyclopedia of Commercial Real Estate Advice”
Member of the Forbes Real Estate Council
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.
5 Reasons Why Multifamily Apartment Cap Rates are so Low
In 2008 when the Great Recession hit, multifamily property values went down or remained flat. The recession was caused by a 6 year bull market where commercial real estate prices kept going up reaching unrealistically high prices that were not supported by reality. The real estate market was also in the hyper-supply phase (see more about this below), which usually means you are buying at the top of the market. Today we are at a similar place, with multifamily prices at an all-time high as a result of inventory for apartment buildings for sale being at an all-time low. This is thought to be a result of the Coronavirus Recession, which unlike the Great Recession which was caused by a runaway subprime loan market.
Conversely, multifamily apartment properties in this recession have been going up in value pushing cap rates way down. Why has this happened? First, this started with residential property values skyrocketing and many multifamily sellers waiting for prices to go up substantially before they put theirs up for sale. Secondly, it is thought to be due to an increased need for housing with vacancies averaging just below 3%, and rents rising at over 8% which theoretically should push prices up. Thirdly, because of the stress the coronavirus put on the economy, almost all apartment starts were either delayed or canceled. Fourthly, to compound this further, banks tightened underwriting and are still shy about lending on new commercial construction today due to the uncertainty of market rents, rental concessions, rental collections, and the time for absorption. A fifth factor is that multifamily properties are without doubt the most popular type of commercial property and are even more in demand. Lastly, with the stock market continuing to go up, many investors fear the bubble is about to burst and preferred to diversify into investing in overpriced multifamily properties, confident that rents and property values will go up in the future.
Are you Buying at the Top of the Market?
So how do you know if you are buying at the top of the market? Supply and demand is the largest control factor on prices. If there are very few properties for sale in the property class and neighborhood you are shopping in, and almost no new construction starts, this is a sign you are purchasing at the top of the market. It is essential to look at the relationship between low cap rates, low net operating income, and how much time it might take you to raise rents and realize the return on your investment.
Most buyers are indeed paying too much for commercial properties when cap rates are historically low, rationalizing that rents can be raised over time. But how much time are we talking about? If it is going to take more than a year for you to reach the cash on cash return you want by raising rents, you are likely paying too much for the property. Now that unemployment and GDP are beginning to return to normal, there will be more apartment construction starts which should eventually supply more units in the market than demand. This will be a much better time to buy.
But if you absolutely have to purchase an apartment property now that has an unattractively low cap rate because you have a 1031 exchange, or cash just sitting there, it is important to ask yourself these two questions: 1.) With such a low return on your cash investment, is it worth it to wait until you can increase rents and eventually increase net operating income and property value? Right now, as in most recessions, rents are flat. This means it could take 2 years or longer for rents to increase enough for you to get decent cash on cash return. 2.) To mitigate this, does the property already have under-market rents, or offer some low-cost operational and/or cosmetic value adds that will allow you to increase rents within a year? These could include lowering expenses – perhaps managing the property yourself, and adding new paint, floor coverings appliances, and fixtures.
Here is my Forbes.com article on this subject: https://www.forbes.com/sites/forbesrealestatecouncil/2021/04/06/are-you-buying-at-the-top-of-the-real-estate-market/?sh=4b37ff503230
Fourth Quarter 2021 Cap Rates
Over the past year, multifamily cap rates in all asset classes fell by an average of 54 bps which on a million-dollar purchase equals an increase in value of $54,000. Not small potatoes. Suburban C Class properties experienced the largest cap rate decline by 76 bps or an increase of $76,000 for a million-dollar property. For the first time, quality Class C properties in good neighborhoods are selling for just about the same cap rate as Class B properties. This just doesn’t make sense when you consider the increased cost for repairs and maintenance with an older Class C property. Value-added properties dropped by an average of 60 bps, which makes it much riskier to reposition or rehab these (See more about this below)
Is it Safe to Rehab a Multifamily Property Today?
With Cap Rates for Multifamily Apartment properties holding at historical lows, value Add Acquisitions are priced at an all-time high averaging a 5.5 cap. This is what a quality C Class property went for just over a year ago, so be wary of overpaying for a property that needs major repositioning or rehab. Unless you can buy it at a very good price per unit, this is not the best time to go this route. With the uncertainty of actual repositioning expenses, future market rents, new construction starts, rental concessions, and absorption times, this can represent a large risk. Historically, value-added investment real estate made sense only when buying at below market value. As a mortgage banker that has made loans on rehab projects since 1997, the largest risk I see today is overpaying for a building and then going over your rehab construction budget. And then compounding the problem taking too much time to complete the construction.
In the first chapter of my book, “The Encyclopedia of Commercial Real Estate Advice” I discuss the four phases of the real estate market cycle and the best time to buy. The market cycle causes there to be winners and losers. Winners are the sellers that sell at the top of the market. Losers are buyers who buy at the top of the market.
The end of the recession phase, when distressed commercial properties are foreclosed on is a good time to buy. This is followed by the recovery phase when unemployment has gone down and GDP has gone up—this is a great time to buy. Then comes the expansion phase – the beginning of which is still a good time to buy. But because it is now a seller's market, prices are going up again. Next comes the hyper-supply phase which is the worse time to buy. Prices are just too high, cap rates are insanely low, but there is an oversupply of units on the market due to new apartment building starts and completed rehab projects. It’s unbelievable that investors are still paying too much for properties – sure that prices will go even higher. You won’t know when the next phase of the real estate market cycle will start, but you can learn to identify which phase you are in so you can make intelligent decisions on purchasing and selling.
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