Cap Rate Outlook: Inflation vs. Investor Demand

December 31, 2013 – Multifamily Executive Magazine 
Cap rates often rise when interest rates rise, but that may not be the case in many markets in 2014.

In the short-term, continued strong demand from equity investors should keep in check any potential hikes to cap rates that buyers hope will accompany higher debt costs.

Most finance experts are skeptical that moderately rising long-term mortgage rates over the coming year would have much if any impact on the apartment sector’s equity yields and capitalization rates—particularly among Class A product where interest is so strong. However, some expect higher debt rates to put upward pressure on capitalization rates of smaller and lesser-positioned properties that attract more high-leverage buyers.

The apartment sector’s strong fundamentals—and prospects for further rental-rate and net-operating-income (NOI) gains—should continue generating heavy competition among investors for high-quality assets. Hence, even if debt rates move up moderately, it’s unlikely that interest among low-leverage buyers would wane, and in turn drive up going-in yields.

The big public REITs aren’t going to bid less aggressively for solid properties simply because multifamily mortgage rates move a few dozen basis points higher.

“We are not expecting any dramatic changes in the cost of (equity) capital” for institutional-grade ventures, says Adam Allen, Houston-based managing director with Atlanta-headquartered Apartment Realty Advisors’ capital markets group

Indeed the high-net-worth types that frequently invest into Village Green ventures are quite comfortable with the low-double-digit, cash-on-cash returns they’ve tended to earn over the past year or two. “Based on our latest discussions, that hasn’t changed,” says Jason Koehn, chief investment officer at Farmington Hills, Mich.-based developer/operator Village Green Cos.

Accordingly solid Class A properties in major markets should continue selling at cap rates generally in the 4.75 to 5 percent range—and perhaps closer to 4.5 percent for such assets likely to see strong near-term NOI growth as rents rise, Allen predicts.

Continued “fierce competition” over core commercial real estate investments in primary U.S. markets may well continue “compressing” equity returns at least during 2014’s early quarters, according to global property services firm DTZ’s Capital Markets Update. The analysis also suggests that amid such heavy yield-eroding competition for top-tier assets, a growing roster of domestic and offshore investors will likely demonstrate greater tolerance for the risk of buying in secondary markets.

But if debt rates rise notably in 2014, cap rates may need to adjust accordingly for the smaller and lesser-positioned apartment properties that tend to attract entrepreneurial types requiring higher leverage.

“It’s simple mathematics” when it comes to yields such investors will expect from these property profiles, says Tim Koltermann, senior vice president at Bethesda, Md.-based Walker & Dunlop. “If the risk-free (Treasury) rate rises and financing costs follow, cap rates are going to go up as well.”

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