As summer turns to fall, a lot of exhausted multifamily investment and finance professionals around the country are wondering whether the scalding apartment sector is hitting—or at least nearing—its cyclical peak.

And with good reason.

Effective rental rates in many markets have risen to unprecedented levels, gobbling up ever-higher proportions of resident incomes. Accordingly, properties are selling at average per-unit prices beyond previous historic highs amid arguably frenzied trading volume. And, thanks in part to ultra-cheap debt financing, the average capitalization rate recorded in major markets compressed to an all-time low earlier this year—with the yields in secondary and tertiary markets closing in on records as well.

Yet, some ominous clouds are bringing the course of further appreciation into question.

Potential Threats to Good Times

One key looming factor is the inevitable end of the long-running, ultra-low–interest rate environment that’s been a major impetus compressing income-property cap rates. Federal Reserve decision makers didn’t pull the trigger and finally start boosting short-term rates in September as many had expected. But the consensus is that the Fed will likely launch the dreaded “liftoff” either in December or early next year, initiating complex processes that will eventually put upward pressure on cap rates—and downward pressure on yield-based valuations.

And given the rapid appreciation of apartment property pricing over the past few years—not to mention all-too-fresh memories of the burst mid-2000s bubble—it’s logical to expect some investor resistance to ever-higher asking prices. Indeed, when the year’s erstwhile eye-popping sales activity hit the skids in July, many a well-versed pundit wondered aloud whether investors had started balking at the ever-paltrier returns available in the multifamily arena.

Another concern—at least for the balance of 2015—is that the apartment sector’s dominant lenders, government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, are already in danger of exhausting their market-rate multifamily loan-buying allocations for the year ($30 billion each), and hence are quoting more-conservative rate spreads and dollar proceeds. And many of the active life company lenders serving the sector are encountering the same issue amid the high-volume dealmaking—perhaps portending some kinks in the sector’s arguably unprecedented liquidity.

But a return in August and September to the previous frenetic trading volume appears to have alleviated these concerns—more like obliterated them, one might argue.

Source: Marcus & Millichap, Sept. 22, 2015, "National Apartment Trends: What Inning Are We In?"


As prolific mortgage broker Eric Tupler observes, the nosebleed prices and thin yields today’s sophisticated investors are willing to accept already factor in prospects of higher debt costs ahead—and, more fundamentally, expectations of ongoing rental-rate and income gains. 

“They’re embedding rent-growth assumptions into the cap rates they’re underwriting—and they’re also baking in [long-term] interest rate increases of as much as 200 basis points,” elaborates Tupler, an HFF senior managing director who’s been arranging purchase financing for numerous apartment investors.

As for legitimate concerns about the GSEs and life companies exhausting their 2015 multifamily mortgage allocations, Tupler is happy to report that commercial banks, Wall Street conduits, and other lender types are anxious to pick up any slack. Competition is tending to keep rate quotes on solid 10-year fixed deals in the mid-3s to low-4s, with leverage ranging to 75% and even 80%, and substantial interest-only (IO) periods remain widely available.

So hang on to your smart phones, all you hyperactive mortgage bankers and apartment brokers—and all your lender/borrower and buyer/seller clients. It looks like the fourth quarter could go down as the highest-volume–ever three-month period for apartment sales (outpacing 4Q2014’s record)—and probably the highest-priced, as well.

More Records to Come

Industry deal trackers, including Real Capital Analytics (RCA) and Marcus & Millichap (M&M), are now projecting 2015 will ultimately beat out 2014 as the most-active multifamily investment year ever. As RCA data indicate, transactions through August had already amounted to just under 75% of 2014’s total of $112 billion—with September, plus the traditionally highest-volume fourth quarter, to follow.

And perhaps even more encouraging for landlords is they can celebrate the new year feeling comfortable that values haven’t yet peaked for the cycle—and probably won’t for at least another two to three years or more.

While caps may not erode further, and the rapid pace of appreciation of late might slow somewhat going forward, “there’s still room for more value gains, so long as net operating incomes continue to grow,” stresses RCA senior vice president Jim Costello.

Sound Fundamentals

Experts, in fact, appear nearly unanimous in concurring that the valuation cycle has far from run its course. Even in the face of rising interest rates, there perhaps remains room for a bit more cap-rate erosion in some markets and property profiles, especially in secondary and tertiary markets. The sector’s supply-and-demand dynamics likewise point to continued improvement in operating incomes going into 2016—and probably well beyond.

Employment growth and demographic realities combine for a bright near-term family-formation and renter-demand picture, led by emancipating millennials and downsizing baby boomers. And the historically low national vacancy rate of roughly 4% is hardly budging, even amid today’s exceptionally active construction pipeline. In fact, starts appear to be tailing off, with M&M projecting about 250,000 unit deliveries this year but closer to 215,000 in 2016.

Source: Marcus & Millichap, Sept. 22, 2015, "National Apartment Trends: What Inning Are We In?"


In other words, underlying the current lofty pricing and low caps is the bottom-line cash flow that today’s necessarily aggressive buyers expect for years to come as rents continue to climb. Even if financing costs and cap rates start rising again, investors tapping low-cost debt to purchase properties at the now meager going-in returns should benefit handsomely from improved NOIs—and even higher values down the road, the consensus holds.

Indeed, in relating the apartment sector’s valuation cycle to a baseball game, many veteran pros insist we haven’t even reached the seventh-inning stretch.

Steve Evans, CEO of Canadian investor–operator Pure Multi-Family REIT, still sees the cycle in its middle innings. The seasoned real estate executive, who is actively buying new developments and opportunistically selling old properties in select Sun Belt markets, foresees “several more years” of solid rental-rate appreciation ahead in markets with decent employment growth.

But as M&M first vice president John Chang stressed during a late-September multifamily investment webinar, job growth and rent-hike prospects are more decent in some markets than others. Hence, determining which inning the cycle is in “depends on which ballpark we’re talking about,” he said during the event. 

Many of the largest metros that have been experiencing strong employment growth have already seen average apartment cap rates compress well into the 4s, with coastal titans New York and San Francisco leading the way, at 3.7%, RCA reports. And, as Chang notes, some of the markets that started recovering later in the cycle are now showing particular promise for even more landlord-friendly supply–demand fundamentals ahead.

For instance, Chicago, Phoenix, and Atlanta are top-12 metros still generating going-in returns above the 6.0% overall national average RCA calculates (year-to-date through August). And numerous secondary markets offering relatively decent current yields appear positioned for exceptional rent growth, including Las Vegas, Denver, and Southern California’s Inland Empire, all of which have seen caps average 6.2% to 6.5% so far this year.

But given the level of investment activity expected over the balance of 2015 and into the new year, seemingly superior yields available in those markets might not hold up for long. As the experience in second-tier metro Portland, Ore., suggests, caps can fall dramatically when a bevy of out-of-state (and out-of-country) equity comes calling.

Striving to improve on those thin caps that top-tier markets and Class A properties are generating, many investors are logically migrating toward promising secondary and even tertiary markets, and also Class B and C communities.

Source: Marcus & Millichap, Sept. 22, 2015, "National Apartment Trends: What Inning Are We In?"


Quick Cap Compression

In a suddenly preferred target market like Portland, intensified competition for close-in B and C assets has compressed caps by upward of 100 basis points over just 12 to 18 months, relates busy dealmaker Phillip Barry, senior broker with Joseph Bernard Investment Real Estate. These properties are now selling at caps in the 4.5% to 5.5% range, with a surprising number of well-located older properties fetching sub-5 caps, says Barry, who’s negotiated numerous local transactions in recent months.

Investors entering the exceptionally tight Portland market are exhibiting considerable optimism that effective asset management and perhaps some capital improvements will boost rental rates sufficiently to move those caps up to 6 or more in fairly short order, Barry adds. “The fundamentals are in place to justify that kind of pricing,” he acknowledges, while also noting that rapidly rising rents are already wreaking havoc for a lot of residents.

Of course, as Barry and others are quick to point out, landlords that aren’t insistent on riding the cycle to the late innings would do well to divest noncore properties at quite attractive pricing today.

“The aggressive buying has lifted the bottom of the market,” Barry advises, “so if you’ve got a dog in your portfolio you’ve been looking to unload, this is the time to do it.”

The same fundamentals-driven dynamics apply in top-tier metros and top-notch product, as well—but, of course, generally at lower going-in yields. Investors targeting these market and property profiles are willing to pay today’s sky-high prices because they’re confident that landlord-favoring supply–demand fundamentals will help them score a lot of runs as the game progresses.

As Evans puts it, the Pure Multi brain trust is quite comfortable buying newly completed communities at 5 caps today while projecting that strengthening rents will boost the yield to a 6 within hardly 18 months or so. Indeed, numerous key demand and supply indicators appear to support the case for continued above-average rent growth over the coming two to four years—and explain why the likes of Evans has to bang heads with a widening variety of private and public, domestic and offshore investors targeting apartments.

Meanwhile, the sector’s liquidity picture might even improve next year, as the GSEs’ regulator is considering bumping market-rate mortgage purchase allocations up to $35 billion each, M&M Capital Corp. senior vice president Bill Hughes noted in the recent webinar. Life companies comfortable with the space seem destined to follow suit, Hughes continued.

He’s also encouraged that overseers are pushing Fannie and Freddie to support more production and preservation of workforce-class housing, along with smaller properties, at the expense of the higher-end and large communities that accounted for so much of the GSEs’ loan purchases in recent years.

And what might that mean in terms of the cycle’s baseball analogy? “I’d say we’re in the sixth inning,” Hughes concluded. “But we could go into extra innings.”