Bob Hart had run Kennedy Wilson’s multifamily shop since 2000. But when one of the Los Angeles–based owner’s big investors, New York–based Guardian Life Insurance, decided to start a real estate operating company, it gave Hart an opportunity to launch his own firm.

In June 2013, Hart, with Guardian’s backing, launched TruAmerica Multifamily and by October was buying apartments with the goal of purchasing $1 billion worth in the first three years. What followed was a 26-month sprint to amass 15,268 units by spending  $3 billion for primarily B apartments in the Western U.S.

So now that Hart has lapped his three-year plan in only two years, you might think he’s going to continue his buying frenzy. Not quite.

“I think we’re all going to sober up in 2016 if the spread between interest rates and cap rates continues to tighten,” Hart said in mid-November, after the 10-year Treasury had jumped 30 basis points in a week. “We’re going to be very, very cautious about price, and we’re going to watch interest rates very closely, because that spread could erode in the short run if rates continue to move up aggressively as they have recently.”

While Hart’s sentiment isn’t unanimous in the industry, there’s definitely an air of trepidation in the market that, with interest rates rising, rent growth potentially plateauing, and muddled geopolitical situations throttling foreign investment, this acquisition window could be closing.

Apartment transactions grew from $103.5 billion in 2013 to $113.1 billion in 2014, which passed 2007’s previous high. By October, 2015’s volume had surpassed that of the year before.

The question is, will the upward trajectory continue into 2016? And, regardless of whether it does, what happens to cap rates?

Trouble Spots

Bob Hart
Bob Hart, CEO and President, TruAmerica Multifamily

One of the big X factors for 2015 was interest rates. Indeed, for Robert Lee, president and COO of Los Angeles–based JRK Property Holdings, the interest rate issue isn’t something on the horizon: He’s ­already seeing its effects.

“People are grappling with underwriting,” he says. “Interest rates are squeezing anyone under contract or closing [who] haven’t locked their rates.”

If rates move up further after the Federal Reserve’s decision to push up short-term rates, once-flowing returns could be challenged.

“We’re going to watch that real carefully in 2016, because we were getting cash-on-cash returns in the 8% and 9% range right out of the gate,” Hart says. “If you’re stretching interest rates, and cap rates aren’t moving as well, you need to be more cautious.”

Caution could take the form of more buyers sitting on the sidelines. If that happens, there are arguments for cap rates going up or down.

“I don’t think cap rates themselves will move. What you might see is less transaction volume,” says Jim Costello, senior vice president at Real Capital Analytics (RCA). “If you bought an asset and get a good yield on it right now, why are you going to sell?

If the buyers are getting a higher cap rate, you won’t have as motivated a seller. Conversely, you might see cap rates go up sharply, because, then, the only stuff that does sell might be more value-add, opportunistic-type stuff.”

If interest rates increase in 2016, equity could find other homes. “If rates rise, other investment alternatives could start looking better as well,” Costello says. “You’re already starting to see the long end of the yield curve go up a bit. Will investors start to see safe, stable yields out of their bond portfolio that they haven’t been able to get for a number of years?”

Another factor that could pull investors back is the volatility of global capital. Middle Eastern investors have been major consumers of apartments, but low energy prices and regional wars could keep money at home.

Then there are Asian investors. This past summer’s Chinese market disruptions have brokers and transaction analysts wondering if the state is forcing those investors to pull back.

“You have some changes in the year ahead where there may be less sovereign-wealth money to move around,” Costello says. “I think the fear in the market is that there are these tailwinds in the market with foreign capital, but that may become a bit of a headwind if things don’t turn around in the commodity countries and China continues to be a bit of a drag.”

Strong Appetite Persists

While rising interest rates and declining foreign investment could slow volumes this year, the systemic supply-and-demand factors that have pushed the industry to new heights over the past half decade don’t appear to be changing dramatically. MPF Research projects rents to jump 4.3% in 2016 as household formation and job growth continue driving demand.

Those factors helped fuel Starwood Capital Group’s buying spree. The company, which was the second-biggest shareholder in Equity Residential when it went public in 1993 after it contributed properties to the REIT, has been in the apartment sector for 25 years. But over the past year, the Greenwich, Conn.–based company has bought or put 67,800 apartment units under contract.

Starwood, which made its name in the hotel world, prefers multifamily, particularly in the Sun Belt markets. In October, its Starwood Global Opportunity Fund X bought 23,262 apartment units from ­Equity Residential.

“We believe multifamily will outperform the other asset classes because of fundamentals: reduction in people moving into homes, good job growth, and pent-up demand from millennials,” says ­Christopher ­Graham, senior managing director and head of real estate acquisitions for the Americas at Starwood. While specific circumstances, like the board at Landmark Apartment Trust deciding it was time to sell 63 properties, drove Starwood’s buys in 2015, Graham sees no reason why the firm won’t have the same appetite in 2016.

“What we’re buying is a carbon copy of what we’ve been doing the last couple of years,” Graham says. “We really like the fundamentals of multifamily. If we’re presented with similar opportunities, I see no reason why we wouldn’t take them.”

If private buyers, like Starwood, remain aggressive, it will probably keep the REITs on the sidelines, for the most part, for another year. In 2015, Green Street Advisors said the publicly traded apartment owners were net sellers, as Associated Estates and Home Properties were pulled off the public markets by Brookfield Asset Management and Lone Star Funds, respectively.

“We’re hearing more anecdotes about levered buyers outbidding the REITs. Right now, the REITs’ cost of equity isn’t advantageous,” says John Pawlowski, a research associate at Green Street. “They’re trading at large discounts to net asset value. To issue equity isn’t prudent. They’re kind of handcuffed there.”

And private buyers can lever up a lot more at this point in the cycle. “REITs are sitting on the sidelines—it doesn’t make sense for them to acquire at this time,” says Britton Costa, director of U.S. Corporates, REITs, for Fitch. “Private equity buyers can put a lot more  leverage on the assets than an investment-grade REIT can. If any REIT will have leverage in that 30% to 45% range on the debt-to-asset basis, and five to seven times on a debt-to-EBITDA basis, you can probably go out and get a GSE-backed mortgage in the 65%-plus loan-to-value range. You can get much higher returns when you use leverage in the private market.”

A big part of the reason private buyers can secure that leverage, especially on large deals, is Fannie Mae and Freddie Mac. In 2015, they played pivotal roles in large transactions, such as Starwood’s purchase of the EQR assets. That shouldn’t change in 2016.

“The smaller, $80- to $100-million transactions would have happened, but the large ones may not have happened if there [hadn’t] been a reliable, dependable financing source,” Graham says. “I don’t see any change, because Fannie and Freddie have $30 billion apiece and fewer restrictions on affordability than they did last year.”

So with Fannie and Freddie’s continued strength and strong demand, maybe sales will continue to rise in 2016. But a word of caution: Mind the potential impediments on the horizon.