Have you invested in an apartment property over the past four years? If you have, there’s a really high probability that it’s gone up in value since you purchased it.
During this time, valuations for apartments across the country have been on an upward trajectory, driving down cap rates to levels last seen in 2005. In many cases and markets, cap rates are now at historically low levels. But with construction ramping up, the property market cycle maturing, and interest rates on the rise, many are now wondering if cap rates have bottomed and will head upward over the next few years.
Defining Cap Rates
So is the game over? In order to determine this, we need to examine how apartment cap rates behave.
The cap rate is usually defined as the ratio of the forecasted annual net operating income (NOI) for a building to the value or price of the building. The numerator of that ratio, NOI, tends to be fairly stable—although fundamentals change over time, there are rarely huge changes in vacancies or rents, though they do occur. However, the denominator of cap rates, the valuation or price of the building, is far more volatile. Sentiment in the market can and does change rather quickly at times. Because of this, most of the variation we observe in cap rates is due to valuation.
Like any other asset class, the valuation of apartments is based on the discounted cash flows that a building is projected to produce. And the general assumption is that as interest rates rise and fall, the discount rate that is applied to apartments also rises and falls, causing values to behave like most other asset classes. However, an empirical examination reveals that this assumption is not explicitly true.
Interest rates tend to rise and fall based on the economic environment—when the economy is performing well, interest rates tend to rise as investors sell out of less-risky investments into higher-risk investments and the Fed raises interest rates to keep the economy from overheating. Conversely, interest rates tend to fall as the economy contracts, with investors doing the reverse: selling out of risky assets and into lower-risk assets while the Fed cuts interest rates to stimulate a sputtering economy. Interest rates are countercyclical.
Apartment fundamentals and investor sentiment, however, are generally pro-cyclical; meaning fundamentals improve and investor sentiment escalates when the economy is recovering or expanding. Similarly, both variables deteriorate when the economy is worsening.
Because an improvement in fundamentals translates into greater NOI for apartments in the future, all else being equal, this relationship should generate an increase in the value of the buildings as the incomes being discounted become greater. Moreover, as the economy improves and investor sentiment increases, investors bid up the value of commercial real estate, partially as a response to improving fundamentals but also because the risk associated with owning apartments decreases as the economy improves. As risk premiums compress, discount rates fall and valuations increase.
This leads to a tug-of-war between the effects originating in the broader capital markets— namely, interest rates—and the effects originating in the apartment markets—namely, the changes in fundamentals and risk appetite.
The Role of Fundamentals
When we examine the data for the past four to five years, we learn that apartment cap rates and interest rates do not correlate very well. We use the 10-year Treasury rate as our proxy for interest rates because of the typically longer holding periods for apartments. Empirically, we observe either a negative correlation or no correlation between interest rates and cap rates.
For example, between the first quarter of 2009 and the fourth quarter of 2013, the correlation between interest rates and cap rates is -0.03. This indicates that the relationship is weak and negative, meaning that movements in interest rates and cap rates during that time were not strongly related and generally moved in the opposite direction.
Long-term interest rates have been rising since 2012 and jumped markedly during the second quarter of 2013. Even if most of the expansion in interest rates that the market was anticipating has already occurred, interest rates are likely to continue to increase.
Do continued rising interest rates portend rising cap rates, as well? What will determine the direction of apartment cap rates is the magnitude of interest rate increases vis-à-vis the improvements in fundamentals, compressing risk premiums, etcetera. Over the next three years, we expect these market forces will be stronger than the increase in long-term interest rates that has yet to occur. Because of this, we anticipate that apartment cap rates will continue to fall.
However, the further out in the future we go, the more the tug-of-war begins to become more even, eventually tilting in favor of rising interest rates. Vacancy rates should continue to drift higher over the next five years, and, even though rents are projected to continue to grow, NOI growth will slow. This will change attitudes in the market toward apartments, especially as the improvement in fundamentals in other major property sectors, such as office and industrial, continues to outpace the improvement in apartment fundamentals.
As capital chases better-potential returns in other property sectors and risk attitudes about the apartment sector shift, an increase in interest rates is likely to cause cap rates to edge higher. Not dramatically so, but higher nonetheless. Therefore, prudent investors would be wise to consider not just the near-term outlook for cap rates but also the long-term horizon, especially given typical holding periods for apartments.
The game isn’t over for apartment cap rates, but it looks like we’re past halftime.
