Building age is a crucial factor in every investment decision, one of the first considerations when picking a core, value-add, or opportunistic strategy. After all, newer and older buildings come with different valuations, affecting investors’ preferences and investment opportunities throughout the cycle.
Yet, as the upturn matures, the gap between cap rates on newer and older buildings may be starting to narrow.
The price-per-unit and cap-rate data by building age (see chart) show how preferences for newer or older buildings have evolved over the last decade. Before the recession, between 2005 and 2007, the price-per-unit premium between newer and older properties went from about 40 percent to more than 60 percent.
Meanwhile, transaction cap rates for newer and older buildings remained close, as a result of high liquidity and optimistic valuations. Then, between 2008 and 2009, as the market slowed down, cap rates increased and prices declined. However, the price per square foot premium was still above 50 percent while the cap rate spread remained very tight.
It was not until the recovery began, in 2010, that cap rates and prices really started to diverge. Newer asset cap rates came down, and prices accelerated faster than those of older properties. Then, in 2011, when investors began to play the value-add strategy more actively, older property cap rates dropped. After that, investor preferences were largely on the side of the newer properties, and the spread between the price and cap rate series remained relatively constant, at over 110 basis points
In 2013, as the upturn began to mature, that cap-rate spread appeared to compress. As of the first quarter of 2014, the cap-rate compression remains subtle, although on average it has led to a gap that is more than 25 basis points narrower than that observed between 2010 and 2012.
This compression comes from two trends. For one, the older property cap rates remain on a downward trend, suggesting sustained interest in established or ready-to-renovate assets, possibly in secondary markets where construction is less widespread. In addition, newer asset cap rates are leveling off, suggesting a possible concern that recent deliveries could be more strongly affected by the growing supply wave.
If the current supply wave has a negative effect on rents and vacancies, the gap between cap rates and prices could continue to close. Investors could continue to have reservations about high-priced assets, possibly favoring older, cheaper properties. Whether the market will head in this direction remains uncertain, but much depends on the amount of capital available for new construction and the appetite developers have for additional risk.
Luis Mejia is director of research, multifamily, for PPR, a CoStar Company, and can be reached at email@example.com.