Jim Hurley, portfolio manager for the California State Teachers' Retirement System, known as CalSTRS and one of the largest pension funds in the country, seems anxious. With cap rates below 4 in some markets (an indicator of high apartment prices) and interest rates rising, CalSTRS and other investors risk negative leverage if they put debt on a property.

"You have to have the wherewithal to cover the cash flows until you see rent growth," Hurley says. "If you're an optimist, you need to plan on 12 to 24 months of negative cash flow. If we see continued increases in interest rates, we will need to pause [buying] until sellers revise their pricing." The fund buys nationally, and its expectations vary by region. Hurley isn't alone in these thoughts. Many multifamily owners who work with institutional investors and pension fund advisers say funds have become wary. But some owners say pension funds see long-term prospects in multifamily investing.

The Tipping Point

The numbers worked for institutional investor CalSTRS and Fairfield Residential Chambray to build the Victoria Arbors in Rancho Cucamonga, Calif.
Brian Pettigrew The numbers worked for institutional investor CalSTRS and Fairfield Residential Chambray to build the Victoria Arbors in Rancho Cucamonga, Calif.

While Hurley is watching to see if prices come down–and continuing to invest in multifamily properties, albeit less heavily than in year–he doesn't have a magic number at which he would flat-out quit buying. "The going-in cap rate versus the interest rate and 10-year Treasury [bond rates] are the things we look at," Hurley says. "If interest rates go up another 50 or 100 basis points without any change in cap rates, we'll have a real issue. It's a very tough time to be a buyer."

David Libman, acquisitions manager for Fieldstone Properties in Parsippany, N.J., works with pension funds that want to put money into multifamily property in Florida and New Jersey. The company specializes in buying class B and C properties and upgrading them with new kitchens, baths, roofs, paint, and windows. In that segment of the industry, Libman thinks trepidation is seeping in, especially in Florida. However, lower cap rates are not the only problem.

"We see pension funds wanting to be in the market, but they are keeping an eye on insurance rates and taxes," Libman says. "They wonder what will happen with insurance costs in the market if hurricanes hit again."

Weighing these factors, Libman says he's identified exactly when his investors would abandon multifamily. "I think the breaking point is 6 to 6.5 percent in cash-on-cash yields at the end of year one," he says. "That moves as bond rates change. If I can get 5.5 percent in the bond market with little risk, why am I investing in real estate at 5.5 percent with more risk?"

Even if institutions snub the American multifamily market, they can still stay in multifamily and beef up investment in other parts of the world. CalSTRS, for instance, is investing in Latin American and Eastern European apartments and looking at multifamily in both China and India.

"Globally, there is a shortage of housing," Hurley says. "There's a shortage of housing in East Asia and in Latin America, for instance. The numbers are dramatic. In Latin America, there's a shortage of 12 million houses. Forty million Russians don't have indoor plumbing. The middle class in China, India, and Brazil is doubling every three years. These people want houses. They want a decent roof over their heads."

Other real estate sectors may also present some options, Libman says. "I think they will shift into office and maybe industrial," he says. "With the trade imbalance and more products coming into the country, they could go to ports. You may see secondary ports picking up traffic. There will be opportunities to get in with industrial plays."