Apartment owners and investors can look forward to another strong year in 2007, as rental rates are expected to continue climbing even after posting their biggest gains in five years. High housing prices, coupled with the steepest interest rates in five years, have pushed many U.S. residents away from homeownership and toward the rental market, and that trend is expected to continue in 2007.

At the same time, as institutional investors continue to flock to the multifamily sector, experts predict cap rates will erode further in some of the strongest markets. For instance, in the high-demand Southern California marketplace, where cap rates have fallen even while effective rents weren’t appreciating substantially, prospects for bigger rent hikes in 2007 may well push cap rates further south, suggested Bob Hart, president of Beverly Hills, Calif.-based repositioning specialist Kennedy Wilson Multifamily.

“We’ve had 20 active players representing different pockets of capital banging heads here for the last few years, and now the expectation is for better rents ahead even as the availability of product is pretty tight,” Hart said. “So it looks like investors are going to have to bear down on cap rates” in expectation that better revenues will eventually boost overall venture yields, he said.

“We’re already seeing some cap rate softening” for properties that tend to have the lowest cap rates already, mainly larger Class A communities in preferred locations, said R. Lee Harris, president of NAI Cohen-Esrey Real Estate Services, Inc., in Kansas City. Nevertheless, cap rates on stabilized top-tier properties still remain “absurd” at 5 percent and in many cases even lower, Harris said.

Awash in capital

With their hoards of cash to invest, institutional capital managers aren’t likely to be too put off by low cap rates, and most likely will remain aggressive buyers, some experts say.

“Pension funds are not going to cut allocations to real estate generally and the multifamily sector specifically,” said Michael Melaugh, executive managing director of capital markets with high-volume developer Trammell Crow Residential in Stamford, Conn. “They have a lot of money to invest, and they like apartments, especially with the ‘echo boom’ kids coming out of school providing favorable longer-term renter demographics.”

Institutional buyers are willing to accept initial yields of 4.5 or even 4 percent for “core”-type Class A properties, because they expect the average annual yield over the hold period to end up at maybe 7 or 8 percent, Melaugh said.

Of course, general debt-market dynamics in the U.S. economy are also bound to play a key role in multifamily yield parameters as the year progresses. And some sources who expect a higher 10-year Treasury yield ahead also see capitalization rates likely to follow the Treasury rate upward.

“If we’re looking out 12 months from now, we’ll probably see somewhat higher apartment cap rates than we’re seeing today,” predicted Gleb Nechayev, chief economist at Torto Wheaton Research in Boston.

Nechayev is anticipating a modest rise in long-term rates in 2007, and history suggests average cap rates will follow. A historic analysis by Prudential Real Estate Investors finds that for every 100 basis-point increase in interest rates, cap rates have tended to rise about 50 basis points. But then again, history hasn’t seen many yield curve environments so inverted as is the case today—nor so much capital chasing apartments, for that matter.

Of course, it’s not just institutional capital, although pensions and the like are clearly leading the charge. New York-based investment tracker Real Capital Analytics reports that institutions account for about one in every four dollars invested in the multifamily sector, and that they’re exceptionally active in acquiring substantial portfolios and high-rise properties. Close behind are regional and national real estate operations, trailed only slightly by local players.

REIT competition

Publishing and research organization Institutional Real Estate, Inc., in Walnut Creek, Calif., counts more than 400 equity real estate investment funds launched just since 2000, with institutional capital backing the bulk of them.

These funds are becoming increasingly diverse—from highly specialized small-cap funds capitalized with less than $100 million in equity, to the latest Morgan Stanley-managed mega-fund targeting $8 billion in investment commitments. While these funds compete with local specialists, they also tend to team with expert operating partners in their target markets.

And don’t forget the sector’s stable of large public real estate investment trusts (REITs), which had become more competitive in the acquisitions arena as debt costs were rising last year, and which appear poised to pounce on development opportunities amid generally improving fundamentals in many markets.

In markets where cap rates move upward in 2007, look for REITs to jump in as yield-based pricing offers opportunities to add to corporate earnings, said Craig Silvers, a principal at REIT securities analyst Bricks & Mortar Capital in Los Angeles. And where REITs can find bargains on land, they’ll actively invest in development ventures.

“Straight property acquisitions prices still rarely make sense for the public REITs right now,” Silvers said. “But I think we’ll see more development sites become available at lower prices, now that homebuilding has slowed so much.” And many of the REITs can be quite efficient developing, given their in-house capabilities and access to attractively priced equity, he said. Rents to keep climbing

Of course, investor enthusiasm stems to a large degree from expectations about multifamily market fundamentals in the coming year. And indications for the most part suggest another good year for landlords.

New York-based data provider Reis, Inc., is projecting average effective rental-rate gains nationwide of 3.6 and 3.5 percent in 2007 and 2008, respectively, following last year’s 4.2 percent (the best showing since 2000). In fact, average effective rental rates have now risen every quarter for two and a half years running.

Average vacancies nationwide are now below 5.5 percent for the first time in five years. And Reis is projecting stable occupancies going forward, with slight upward movement toward the 95 percent mark by the end of the decade. Reis is also projecting modest gains in both absorption and completions for each of the coming four years, with both figures still well below the cyclical peaks in the mid-1980s and late-1990s.

While apartment development activity isn’t exceptionally heated, investors are nevertheless concerned about additional new supply stemming from distress in the condo world, said Sam Chandan, chief economist at Reis. This includes not just individual condos hitting the rental market, but also entire properties being “re-converted” to rentals and development projects “re-purposing” from for-sale to the rental market mid-stream, he said. “We are projecting that a slowdown in conversions will increase the rental inventory,” Chandan said.

As for regional performance prospects, Reis projects that some of the California, Florida, and Washington, D.C-vicinity markets might see average effective rent gains of close to 5 percent this year, while some Midwestern markets such as Indianapolis and Columbus might not hit the 2 percent mark.

As year-end approached, Real Capital Analytics was still seeing average caps at 5 percent or lower in key California markets along with greater New York City. Activity in and around the Big Apple has in fact dragged average caps in the entire Northeast region below 5 percent, followed by the West at 5.5 percent, Mid-Atlantic at 6.3 percent, Southeast at 6.6, Southwest at 6.7, and Midwest at 7.2.