About Multifamily Apartment Cap Rates Today
By Terry Painter/Mortgage Banker
Author of: “The Encyclopedia of Commercial Real Estate Advice”
Member of the Forbes Real Estate Council
Why are Multifamily Apartment Cap Rates 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. Today we are still in the Corona-Virus Recession which unlike the previous recession was caused by a pandemic. But surprisingly, multifamily apartment properties in this recession have been going up in value pushing cap rates in a downward trend. Why has this happened? First, this is thought to be due to an increased need for housing with vacancies averaging just below 5%. This has been compounded by low inventory on properties for sale and the decrease in multifamily construction starts. Banks are barely lending on new commercial construction due to the uncertainty of market rents, rental concessions, rental collections, and the time for absorption. Secondly, with retail, office and hospitality properties tanking, more investors are fleeing to the safety of investing in multifamily properties.
Are you Buying or Selling 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 pay 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. Once unemployment and GDP 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 increased enough for you to get a 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.
Cap Rates for Multifamily Apartment Properties are Holding at Historical Lows
Cap Rates for Multifamily Apartment properties are holding at a historical low for 2021- averaging a 5 cap or even lower for newer A and B Class, and 5.34 for C Class. Value Add Acquisitions are priced at an all-time high averaging a 6 cap. 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 future market rents, new construction starts, rental concessions and absorption times, this can represent a large risk. An even bigger risk is going over your rehab construction budget and 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 sellers-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.