A bubble in the apartment market? That’s what some people are saying. Undoubtedly, prices are expensive. Yet, “expensive” and “a bubble” are two different things.
A financial bubble is generally defined as trading in an asset market at a price or price range that significantly deviates from that asset market’s intrinsic value. Bubbles are difficult to spot a priori because it’s difficult to determine intrinsic value on a real-time basis. Therefore, it’s usually after the fact that it becomes apparent a bubble existed, and that’s why many people today incorrectly believe the apartment market is in a bubble. However, a careful examination of the current market relative to the last bubble will demonstrate that there is no bubble today.
Apples to Apples
The main culprit leading people astray is historically low cap rates. But why are cap rates so low? For some insight into this, let’s compare cap rates from 2006, 2007, and 2008 (when the apartment bubble finally burst) with cap rates from the past few years—2013, 2014, and 2015. (Therefore, we’ll compare 2006 with 2013, 2007 with 2014, and 2008 with 2015.)
I chose these years not only to compare the current environment with the times during which the bubble burst, but also because the recovery/expansion periods in the economy are of similar length and make for an apt comparison.
After the dot.com recession of 2001 ended, there were 28 quarters until the apartment bubble burst. In contrast, there are 26 quarters between the end of the recession and the fourth quarter of 2015.
Here, I’m using12-month rolling cap rates because we don’t yet have finalized data from 2015. For the other years, the 12-month rolling cap rate is the average cap rate for each year (see first table below).
The differences between these cap rates show how similar recent cap rates have been to cap rates from before the recession. These similar cap rates are why many people believe another apartment bubble has formed. Only by analyzing the forces behind these cap rates can we make the determination that we are not in a bubble currently.
To do this, it’s important to analyze the differences between the components of a cap rate, the risk-free rate of return, and the risk premium from before the recession versus the past few years.
The higher the risk-free rate of return, the higher the cap rate should be, all else being equal. This is because any investment should compensate for its risk (the risk premium) plus the risk-free rate of return.
Due to the relatively long-term holding periods for apartments, the 10-year Treasury rate is often used as the risk-free rate of return. So it is instructive to look at the 10-year Treasury rates from the years before the recession versus the past three years. There are significant differences between rates during these periods: about 2% for each of the first two calendar-year comparisons and not quite 1% for the last comparison (see next table, below).
This last difference, however, is a bit misleading, because the 10-year Treasury rate fell dramatically during the flight to quality in 2008. Prior to that, the difference was closer to the 2% that we see for the other years.
The instinct is to conclude that a bubble exists today because the Fed is keeping interest rates artificially low, depressing cap rates and increasing market values relative to intrinsic values. However, the Fed can only affect nominal interest rates in a limited way and on a short-term basis.
Don’t Let the Fed Go to Your Head
The more critical component to examine here is real interest rates. The ability of the Fed to influence them, especially over the long term, is limited because real interest rates are primarily determined by the real growth rate of the economy. Therefore, interest rates are low because of low inflation and low economic growth, not artificial Fed policy.
This means the risk premium today is roughly 200 basis points higher than it was in 2008 before the bottom dropped out of the market. That level of risk premium doesn’t imply that the market is in a bubble. In fact, that risk premium is relatively high by historical standards and provides an ample return for many investors. If anything, this analysis shows that the risk premium during the last bubble was too low.
Is today’s market expensive? Sure. A bubble? No. This doesn’t eliminate the possibility that one could form in the future, but in early 2016 a bubble doesn’t exist.
