Cap rates likely on the rise in 2006

Many multifamily finance professionals seem to view 2006’s expected rising-interest-rate environment as something of a good news/bad newsscenario.

Yes, late-2005 momentum implies long-term rates are finally headed higher after the Federal Reserve’s steady 18-month upward push of short-term rates, most prognosticators agree. But the Fed’s inflation-busting tight-money policy, expected to continue into 2006 as new chairman Ben Bernanke assumes Alan Greenspan’s duties, also suggests economic growth will boost renter demand and hence improve property operating incomes.

Long-term rates indeed appear headed further north, “but overall that’s not necessarily a bad thing,” said Michael Schall, chief operating officer at Essex Property Trust, a West Coast multifamily real estate investment trust (REIT). The Fed’s actions reflect expectations about stronger economic activity, so the implication is that employment and hence resident demand and lease rates will likewise strengthen, he elaborated.

“If you give me the choice between a lousy economy with lower rates and a better economy with higher rates,” Schall added, “I’ll take the rising-rate environment every time.”

Higher debt costs necessarily produce lower investment yields for leveraged investors absent adjustments in capitalization rates, which are a function of immediate-term net operating incomes (NOIs). Hence, in addition to uncertainty over the extent of 2006’s long-term rate movement, perhaps the biggest question on multifamily minds as the new year begins is just how closely cap rates will track permanent mortgage rates upward.

The consensus among Apartment Finance Today’s expert sources is that cap rates seem bound to rise somewhat as 2006 progresses — but probably not quite as much as long-term debt costs. Indeed Schall and others point out that as of mid-December, cap rates hadn’t yet demonstrated any upward movement even after a few months of rising long-term interest rates.

Long-term mortgage rates have been creeping up, “and the expectation among buyers seems to be that cap rates will have to follow,” said David Baird, national director of investment brokerage Sperry Van Ness’ multifamily practice. “We haven’t really seen cap rates start moving upward in the coastal markets in particular, but it seems it’s bound to happen.”

The 10-year Treasury rate, a key benchmark for permanent mortgages, started moving upward from below 4% last summer to nearly 4.7% in November before moving back into the 4.5% vicinity in early December. The Mortgage Bankers Association is projecting increases in long-term yields of 40 to 50 basis points during 2006.

Multifamily lenders of late have typically been quoting rates in the vicinity of 100 basis points over the Treasury rate, although the spread can be substantially narrower or wider depending on the borrower, leverage, risk and other factors.

The effects of Fed policies

Though it’s not absolutely clear how long the Fed will keep pushing up the short-term Federal Funds Rate, policymakers appear to be targeting a 10-year Treasury rate of 5% over the near-term horizon, according to Michael Melaugh, executive managing director of capital markets with Trammell Crow Residential (TCR). That would tend to push coupon rates to 6% or more for borrowers accustomed to the low-5s or better.

That’s going to make things even tougher for investors already pinched by “negative leverage,” said Rick Wise, director of acquisitions at active multifamily investment adviser Waterton Associates. “If you’re buying at a 5% cap and your debt cost is 6%, your leveraged return is just 2% or 2.5%.” So, if mortgage rates continue upward, leveraged yields of 1.5% or less might not be far off – unless cap rates adjust accordingly, Wise added.

But thanks in part to the lofty prices condominium specialists have been willing to pay for conversion candidates, multifamily cap rates actually declined more than any other property category in 2005, according to the National Real Estate Index (NREI). The nationwide average for Class A communities fell 120 basis points to 6.2%, but many markets and property profiles have seen much lower yields.

Activity at high-volume lender Meridian Capital suggests that as long-term rates rise, investors clearly expect cap rates to follow, according to managing director Andy Weiss. “I can say that pretty confidently looking at my current work flow,” said Weiss.

While Weiss isn’t necessarily convinced the Fed will continue its tight money posture throughout 2006, he stressed that investors are focusing on specific cash-on-cash yield targets. That leaves little doubt going-in cap rates will have to adjust upward with higher debt costs, he said.

The cap-rate question

Others are more skeptical about cap rate appreciation, given the huge influx of equity chasing apartments today – and the likelihood of even heavier competition as NOIs improve.

Cap rates may well rise somewhat as investors look to maintain cash-on-cash yields, but the movement is highly unlikely to be in “lock step” with mortgage rates, said Linwood Thompson, managing director overseeing investment brokerage Marcus & Millichap’s (M&M) multi-housing group. “Interest rates aren’t everything,” he added.

Indeed, improving rental rates and operating incomes could attract even more investment capital into the multifamily marketplace – and thus limit the upward movement of cap rates, added TCR’s Melaugh.

Some experts go so far as to question whether cap rates in the strongest-growth markets will even budge as mortgage rates rise. Institutional investors are making the nation’s premier apartment markets (such as Los Angeles, Washington, D.C., and New York) so competitive that “if anything there’s pressure on pricing to continue upward,” said R. Scot Sellers, chairman of the Archstone-Smith REIT.

For similar reasons, some veterans wonder whether the Fed under Bernanke will be able to drive long-term rates higher. Despite the Fed’s expected continuing push for higher overnight rates to keep inflation tame, Thompson doesn’t necessarily anticipate much pressure on long-term rates, at least during the first half of the year.

A key factor here is that offshore capital that is targeting long-term U.S. Treasuries has tended to keep the corresponding bond yields from paralleling short-term rates upward. And it appears that even more foreign investors are now buying the 10-year benchmark bond, further reducing upward pressure on the yield.

“It looks like the bond market is still trying to defy the Fed,” agreed Thompson’s colleague Dan Dulin, an active M&M agent in Phoenix.

Of course, any changes in individual property values will presumably reflect both the direction of cap rates in a given marketplace and changes in the project’s NOI. And values generally appeared to be at a peak as the new year approached. The NREI calculated that values typically rose more than 10% in 2005 (to a nationwide average of $132 per square foot), with 58 of 61 markets tracked recording gains.

Market differentials

Topping the most-vulnerable list are markets with little or no economic growth, and those due for a correction from rampant condo activity.

Essex’s Schall cautioned that certain markets demonstrating sluggish growth could potentially see property values decline at double-digit rates. M&M’s Thompson said valuations in the frothiest of condo-driven markets could see corrections of perhaps 5%, or even 10% in exceptional cases, if permanent mortgage rates and cap-rate requirements rise notably as the year progresses.

While higher cap rates inherently translate to lower pricing – all else being equal – experts also stress that better incomes should cushion the downward pressure on property values. For instance, a landlord able to raise effective rental rates 6% to 6.5% can offset the impact on cash flow of a 100 basis-point hike in the mortgage rate, M&M’s Thompson calculated. And many investors indeed seem comfortable that free-rent periods will “burn off” near-term, and that contract lease rates will move up modestly as well, he added.

Recent rent and occupancy statistics seem to support their conclusions. As of the end of 2005’s third quarter, vacancies nationwide were down to 5.8%, the lowest level in three years, reported research firm Reis, Inc. Average effective rents increased 1.2% during the third quarter alone to $895 – the strongest quarterly performance in more than four years.

As the holiday season approached, many multifamily players were also adjusting strategies in anticipation of the expected lag between interest-rate and cap-rate movement. A lot were logically looking to lock in long-term fixed debt before it becomes more expensive, and some are even shifting methodologies for calculating investment yields.

For example, the Essex trust continues positioning its balance sheet for higher mortgage rates by issuing long-term fixed-rate debt, Schall said. It’s something of a no-brainer for a big public REIT, given the upward interest-rate movement already under way. “That’s a key strategy for hedging against higher cap rates.”

The typical private investor using mortgage debt to finance long-term deals should likewise stick with fixed rates amid today’s environment, said Meridian’s Weiss. Given the narrowed gap between fixed-rate deals and the starting rate on floaters, it would be downright “foolish” to expose an asset to floating-rate risk on a permanent mortgage, he added.

“Floating-rate loans really only make sense today if you’ve got an unstabilized property and your business plan is to sell the asset – and you can’t find a high-leverage fixed deal,” said Weiss.

New focus for measuring yields

The multifamily market is seeing a burgeoning movement toward forward-looking internal rates of return (IRR), rather than going-in cap rates alone, as the methodology of choice for measuring investment yields. “We’re seeing more of a realization that it’s okay to capitalize income that’s not there yet, to value an income stream more as a motion picture than a snapshot,” said Linwood Thompson, managing director of multi-housing at Marcus & Millichap.

“Most investors still say they’re bidding based on the cap rate, but a lot of the players actually winning the deals are bidding based on IRRs” and factoring in expected improvements in market fundamentals and NOIs, said Thompson. “These guys are rationalizing a 5 cap by saying it’s not really a 5 cap – it’s a 13% leveraged IRR and we should feel good about that.”

Likewise Michael Melaugh, executive managing director of capital markets at Trammell Crow Residential, sees pension funds justifying the low cap rates they’re getting with projects under development by relying more on pro forma projections. Some also look to boost IRR projections by simply reducing the expected hold period from traditional timetables.

“It’s just playing with the numbers,” he concluded.

Rate watch

Though no one expects interest rates to drop, economists and industry experts are much less willing to put a number on where rates are going compared to last year. But a few are willing to stick their necks out:

• The 10-year Treasury rate, a benchmark for permanent mortgages, rose from less than 4% during the summer to about 4.5% in early December. The Mortgage Bankers Association expects long-term interest rates to increase 40 to 50 basis points during 2006.

• Federal policymakers appear to be aiming at a 10-year Treasury rate of 5% in the near-term, said Michael Melaugh, the executive managing director of capital markets with Trammell Crow Residential. That could push coupon rates to 6% or more.

• Rising rates will also affect home mortgages: “We expect a very slow climb in the 30-year fixed, to 6.7% by the end of 2006,” said National Association of Realtors spokesman Walter Molony.