One of the key metrics that multifamily investors consider before pulling the trigger on a deal may not be what it appears.
The spread between the yield on the 10-year Treasury and a given capitalization rate is also called the risk premium—and the wider that spread, the better. In the frothiest days of the last boom period, in late 2006, that spread was around 90 basis points (bps), a razor-thin margin.
With the 10-year Treasury still around 2 percent, and the average cap rate around 6.5 percent, today’s average risk premium is a healthy 450 bps. But given the Treasury Department’s concerted effort to keep interest rates low, can today’s risk premium be trusted?
“We’re in a world with artificially low interest rates, and the question is, are cap rates also artificially deflated?” says Mike Kavanau, senior managing director in the Chicago office of Holliday Fenoglio Fowler. “That relationship between cap rates and Treasuries is not as valid an indicator as it was for the last 50 years.”
There are other considerations that make a cap rate in the 4 percent to 5 percent range a more palatable bet when underwriting exit strategies. Investors are only going to pay that kind of price for a very high-quality asset in a core market, which will always be in demand. Fundamentals also come into play in a big way when penciling out a core deal—many investors are hanging their hat on aggressive rent growth in those markets.
But rosy forecasts of rent growth also must be taken with a grain of salt. Sure, the apartment industry has demographics on its side, but how much can rents be pushed over the next five years?
“That’s the bad news: will the rent growth be there?” asks Hessam Nadji, managing director of research at Encino, Calif.–based Marcus and Millichap. “If you look at wage growth for renter households versus the kind of rent growth that some of this modeling requires—high single-digit, maybe even low double-digit rent growth—you wonder if the wage growth really supports it.”
There’s also a widely held belief in the multifamily industry in “renter nation,” the assumption that there’s been a paradigm shift in this country, that homeownership isn’t as desirable as it once was. For the immediate term, that’s true—it’s harder to qualify for a mortgage than it was six years ago. But is the falling homeownership rate really a structural shift, or is it cyclical? In a couple of years, interest rates may still be low, and job growth might come back in earnest.
“At some point, maybe in 2013 or 2014, there’s going to be a wave or two of renters buying homes and condos again,” says Nadji. “That’s another threat to the logic that we’re going to see tremendous rent growth. There’s certainly a significant preference for renting now, but that doesn’t mean you’re not going to lose a lot of renters to home buying at periods of time.”
In the end, the risk premium is just one way of looking at a transaction. An unleveraged internal rate of return is a primary metric for many investors, and a movement in interest rates doesn’t impact that as much. And if a buyer is underwriting a deal based on the availability of a 10-year loan priced at 4 percent and then interest rates move suddenly, they can do a little “duration migration” and move to a seven-year deal with a lower rate to make the assumption work.
But in terms of fundamentals like rent growth, and demographic considerations like the flight to homeownership, a word of caution is in order. And for investors using today’s low yield on Treasury bonds to justify a purchase, you might want to look for a different baseline.