Core Reaction

The swift pace of cap-rate compression over the past year continues to delight sellers, frustrate investors, and lead to talk of overheating in the multifamily sector.

THE INDUSTRY HAS become the darling of commercial real estate investment due to a combination of strong fundamentals and a lack of viable investment alternatives. The stock market continues its schizophrenic pace, and 10-year Treasury bonds are yielding around 2 percent. In short, where else can investors put their money to achieve the same kind of stable returns?

“Is it getting overheated? You can make the argument, but there are very few places to put institutional money right now,” says Mark Beisler, chairman and CEO of Columbus, Ohio-based Red Mortgage Capital. “People are willing to accept a much lower return for quality apartments in high-demand areas, just to get the money out.”

But the cap-rate disparity between primary and secondary markets is beginning to flatten, a trend that's likely to grow in 2012. Investors are increasingly balking at the price tags on Class A assets in the nation's largest markets—where cap rates are consistently below 5 percent— and reassessing their options.

“Everybody wants to be in the gateway cities and Class A product, and they've driven the yields so far down that there's been a rebound effect,” says Gary Mozer, managing director of Los Angeles–based George Smith Partners. “Stuff was selling in Los Angeles at a 4.5 cap, and now it's a 5 cap again.”

At a sub–5 percent cap rate, the math an investor needs to make that investment a long-term win is pretty aggressive in terms of NOI growth.

“I don't think cap rates are going to compress much more in the core, A-quality assets. There's caution in the wind, and that's probably appropriate,” says Bill Hughes, managing director of Encino, Calif.–based Marcus and Millichap Capital Corp. “Where you could continue to see some cap-rate compression is on some lesser-quality assets in smaller markets.”

But it's a delicate balancing act. Capital is still looking for a home because other markets haven't yet recovered. Yet, if you're still looking for capital, or looking to sell, you may not want the broader economy to recover too quickly.

“We need job growth, but the other end of the sword is, when jobs increase, you might see inflation, and fewer people interested in buying apartments because there are other options,” says David Ravin, president and CEO of Charlotte, N.C.–based Northwood Ravin. “If you're just starting to build or looking for capital, you're hoping that the capital remains in multifamily long enough for you to capture it.”

 

A YEAR AGO, nobody thought they'd ever see it again. A year later, everybody's wondering how long it can last.

The permanent-debt market has featured some of the lowest interest rates in history over the past 18 months. Long-term fixed rates in the low–4 percent range have helped push cap rates down to pre-recession lows in some markets, while driving a wave of refinancing.

The yield on the 10-year Treasury entered uncharted waters in 2011, dipping to 1.67 percent in September, and hovering around 2 percent well into December. Not even a downgrade of our nation's credit rating could stop the benchmark's downward march.

Fannie Mae and Freddie Mac again captured about two-thirds of the market for permanent debt in 2011. Life insurance companies grew more active, the banking sector got its appetite back, and there was even a brief window in the spring when it seemed like commercial mortgage-backed securities (CMBS) had come back for good.

Borrowers were still locking rates in the low–4 percent range as 2011 came to a close. And there's no reason to think this can't go on for another year, right?

Well, hold your horses, folks, and seize the day. A year from now, we may wonder where it all went.

“What goes down must come up,” quips Freddie Mac's Brickman. “Nobody could've guessed how steeply rates would fall, and you have to run that in reverse. Just when everybody believes we're in for a long run, that's when things get shaken up.”

The equity market has been equally liquid, and many expect it to improve further this year, as return expectations continue to inch down. And all of this capital is building on the momentum of an industry that has become the darling of commercial real estate. Rents are rising as fast as vacancies fall across the nation, and given all the favorable demographics, the wind is gusting in the industry's sails.

But in the end, all of the hands that work in the multifamily industry are shaken by the invisible hand of government.

The government-sponsored enterprises (GSEs) have been the multifamily industry's stimulus plan, keeping values high while daring private-sector lenders to compete. And the resulting competitive landscape, combined with the Federal Reserve's Quantitative Easing program, means that these low rates will continue in the near term.

“I'm betting Bernanke keeps rates low. It's an election year, too, and that comes into play,” says Mark Beisler, chairman and CEO of Columbus, Ohio–based Red Mortgage Capital. “Inflation hasn't reared its ugly head—the bigger concern has been deflation. And if you're a variable-rate borrower, you're sitting pretty right now and for at least another year.”

Plurality

Balance-sheet lenders bounced back in a big way in 2011, as life companies slugged it out at the upper tier of the market, and many regional and national banks began winning more short-term business. And while the GSEs will again take the lion's share of the debt market in 2012, their looming presence should start to ebb back down to earth.

“The level of dominance by the FHA and GSEs has been truly historic, but I expect their market share to shrink as other lenders come more fully back into the market,” says Todd Trehubenko, managing director of multi family for Bostonbased CWCapital. “It's going to continue to swing back toward a more typical environment.”

Many life insurance companies are indicating that they'll have a bigger appetite for commercial real estate investments this year, which may force the traditionally picky sector to start expanding its credit box. But most likely, it will stick to its guns with low-leverage, high-quality deals.

“In 2011, life companies went from 10 mph to 100 mph,” says Marcus & Millichap's Hughes. “The question becomes, can they go from 100 to 110? Could they go from a 65 percent to 67 percent LTV loan? Sure, but I don't see that being much of a change.”

There's also been increasing activity coming from the banking sector, especially in the fiveyear loan space, though some are now going out as far as seven and even 10 years. It began at the local level, but larger banks such as Wells Fargo, PNC, and Capital One are growing more aggressive with each passing month.

The missing link, the wild card, is the CMBS market. The sector was quoting loans at least 150 to 200 basis points above the GSEs in December, and nobody can say just when it will again be competitive for multifamily deals. Still, the CMBS loans closed over the past year or so have been among the safest in history, featuring conservative underwriting and slowly attracting more investor interest.

“I think CMBS will bring more money into the market because more money will come to CMBS,” says George Smith Partners' Mozer. “If it's not a life company or GSE deal, there's demand there.”

Window of Opportunity

A trickle down of both debt and equity into secondary and tertiary markets will slowly occur in 2012. Interest rates will likely stay low, which will help keep cap rates down—and inspire more talk of overheating. But the investment climate today is very different from that at the height of the last boom market, especially in terms of risk premium. When the apartment transaction market peaked in late 2006 and early 2007, the spread between the average multifamily cap rate and the 10-year Treasury rate slimmed to just 90 bps. Today, with the yield on the 10-year Treasury around 2 percent and the average cap rate above 6, that spread is well over 400 bps.

Of course, the giant caveat to any capital mar kets outlook is to expect the unexpected. The debt crisis in Europe will take some time to unwind, and who knows what's around the corner? So enjoy this window of opportunity while it lasts—we might never see these rates again.

“2012 is a political year and I think it's going to be status quo— we'll bump along with good months and bad months for a while,” says Mozer. “But all bets are off after the election.”