While newspapers and magazines have been marveling at historically low mortgage rates, the story to watch in multifamily has been the incredible slide of cap rates. Despite weak apartment fundamentals, cap rates have fallen from their historical levels to lower than 5 percent in some hot markets. Such trends have resulted in new strategies at many apartment firms, as they assess the best ways to operate in such an environment. In this edition of Conference Call, you'll hear the stories and strategies of three high-level multifamily executives: Keith Oden, president and COO of public REIT Camden Property Trust; Leonard Wood, CEO of Atlanta-based Wood Partners; and Keith Harris, executive vice president—investments of the Chicago-based Laramar Group.
When cap rates began falling, what did you think would be the bottom?
KEITH ODEN, Camden Property Trust: To see the cap rates go below 5.5 percent on non-condominium transactions was a shocker to me.
KEITH HARRIS, Laramar Group: The first thing we noticed a few years ago was less the reduction in cap rates than it was the compression of cap rates. There used to be a nice spread between cap rates at A, B, and C properties, and that started going away. Suddenly people were paying up front for the opportunity associated with a B or C property. That was the first inkling that things were changing, and that was amazing.
LEONARD WOOD, Wood Partners: I've always been a believer that apartments are just alternative investments [with cap rates hovering between bonds and stocks]. When the 10-year Treasury bond yield is in the 3 percent range, apartments have typically been a few hundred basis points above that yield. The stock market is not offering more than 8 percent. So it doesn't surprise me at all that cap rates would be 5 [percent]. ... That seems appropriate, given what else you could do with your money.
HARRIS: I haven't seen a lot of cap rate movement recently. Have you, Leonard?
WOOD: No. The only thing I hear about are some of the condo deals, and they're not really cap rate plays. They're "what is the property worth for sale," so when you convert them to cap rates, they are really low.
ODEN: You've got to take the condominium conversions out of the equation. Those are clearly an anomaly that are attached to this piece of the cycle. ... In Washington, D.C., south Florida, and California markets, we have seen assets—not condominium conversion deals—trading at a 4 [percent] handle. If you take your measure of the 10-year Treasury bond yields, which is something we benchmark all the time, we're well inside that 100-basis-point spread. That just strikes me historically as a very full price.
But condo deals are influencing transactions when you are competing against condo converters to purchase apartment properties. How can you say it's not a factor?
ODEN: When I say "factor," I mean something that will influence prices for the next three to five years. If Treasury bonds remain at sub-4 [percent] yields, then I think it's perfectly logical, as Leonard laid out, that we'll be at sub-6 [percent] cap rates on existing assets. But when you start seeing apartments trade at cap rates of 2.5 percent to 3 percent on existing income streams, it's clearly being driven by condominium converters.
Leonard, you have suggested that these lower cap rates might be a longer-term shift. Can you explain?
WOOD: With the transparency of the REIT industry, the information available about supply and demand, and the fact that real estate weathered this recession very well, most people have been willing to reduce the risk premium on apartments. There is better knowledge and information, and you can invest with more certainty now [than in the past].
HARRIS: Traditionally, people discounted real estate returns (i.e., expected higher yields) relative to other investments because of the lack of liquidity. The REIT industry has helped change that. Pension funds also have increased their allocation to real estate. Both resulted in more capital chasing apartment deals, which lowers cap rates. Real estate intrinsics also feel a little better. The places that don't make sense—and it's clearly the capital chasing them that's driving these [trends]—are condo conversions and opportunity deals. I think there is just a little too much frenzy in what you're seeing.
Keith Oden, you're the only REIT executive on the line today. What are your thoughts?
ODEN: There's no question that the market today is driven by liquidity, which is affecting the availability of financing and the structure for these deals. ... As long as the liquidity is there and debt financing is readily available and historically cheap, you're going to see pricing at these levels. Apartments are viewed as a less risky asset class than they were just several years ago. The risk premium is always going to be there, but it's probably been compressed for structural and capital-driven reasons.
How have you responded?
HARRIS: By being very aggressive sellers. If I can't compete on the buy side, I might as well be a seller and take advantage of this environment. ... We have also looked for alternative sources of capital that are cheaper.
WOOD: It has affected us in two ways. These are excellent cap rates, so we've tended to sell more than we would have normally [and] have been more aggressive in following our customer and moving into the for-sale world, with for-sale product and conversions.
ODEN: We made the conscious decision—predating the Summit Properties merger—that in this environment, we were better off putting our capital toward expanding our building program. ... We [also want to] take advantage of the compression of cap rates. ... As long as we can sell the bottom of our portfolio and take those proceeds to fund a development pipeline that has a 300 basis point to 400 basis point spread to the 10-year Treasury, that looks like smart business for us.
What are your predictions for the rest of the year?
HARRIS: I don't see further drops generally across the board, although there are certainly some markets ... where cap rates could continue to go down because of the condo converters.
WOOD: I feel like things will be more or less the same.
ODEN: Our planning horizon includes a 25 basis point to 50 basis point increase in rates on the 10-year over next 12 months. ... What probably will work to keep cap rates flat is liquidity and evidence that fundamentals are improving. As the cash flows improve, I think that will offset the increase in cap rates.
Anything Else To Mention?
WOOD: These low cap rates and high sales prices are fundamentally changing our markets. It's not lost on [land sellers and other investors] that big prices are being paid. Construction costs are also up. What that's meant to south Florida is that we haven't been able to find a site that works economically [for apartments]. The rents have not caught up, so there's no new for-rent production there. That's happening in other markets that have seen high sales prices for properties.
HARRIS: Sellers also have an amazingly high level of expectations right now. They see what their neighbors, their friends, and their peers at the country club are getting [for their properties], and they're raising the bar. Brokers are feeding it to an extent, but I've heard more anecdotes recently about sellers pushing their brokers up in [price] than vice versa.
ODEN: It's as if the sellers are already presuming an exit strategy through a [condo or built for-sale] conversion. ... We're very happy that we already have a $1 billion development pipeline to work on, because finding a deal that can work at these economics is incredibly challenging.