With both inflation and interest rates rising, following the first Federal Reserve rate hike in three years, many multifamily investors are fearful about the impact these duel forces will have on apartment cap rates, which have trended downward over the last twenty years.
In Q4 2021 apartment cap rates reached a low of 4.7%, down 30 basis points since the prior year, according to apartment transaction data tracked by Real Capital Analytics that the National Multifamily Housing Council cited in a recent post.
Just ‘Aggressive’ Enough
Interest rate hikes that are too aggressive could put a damper on economic growth prospects, which would have an adverse impact on property values and upward effect on cap rates, NMHC said. Cap rates could also potentially face upward pressure in markets with diminished rent growth projections, as seen in the San Francisco and New York City markets over the past five years.
Still, apartment cap rates are fundamentally a real rate of return that should only be affected by changes to the real rate of interest, the association said, noting that “apartments, given the short-term nature of their leases, are uniquely positioned to simply re-price their rents during inflationary periods in order to offset higher nominal interest rates.” The NMHC points out that even though the 10-year Treasury has already inched upward, the apartment market continues to benefit from historically high occupancy rates and rent growth, causing cap rates to further decrease.
Furthermore, with apartment transaction volume at record levels, investors may simply be willing to accept a lower premium for holding apartment properties.
NMHC reported further on reasons why nominal interest rates may have less of an impact on cap rates than might be expected.
Weak Correlation Between Nominal Interest Rates, Cap Rates
Interest rates influence borrowing costs for investors. For decades, declining long-term interest rates have bolstered the value of apartment properties, causing cap rates to decrease.
Still, the correlation between long-term interest rates (represented by yields on the 10-year Treasury) and apartment cap rates is not particularly strong, NMHC said. For example, the market yield on 10-year Treasuries increased from 3.6 percent in 2Q 2003 to 5.1 percent in 2Q 2006, during which time apartment cap rates decreased from 7.6 percent to 6.4 percent.
Ten-year yields also rose from 1.6 percent to 3 percent between 3Q 2016 and 4Q 2018, while cap rates edged down slightly from 5.6 percent to 5.5 percent. And, most recently, 10-year rates rose from 0.7 percent in 3Q 2020 to 1.5 percent in 4Q 2021, all while apartment cap rates decreased to record lows.
Cap Rates as a Real Rate of Return
The context around why nominal interest rates are rising is also important. Since the most recent rise in 10-year Treasury rates was simply in response to higher inflation, there hasn’t been much of a change to the real, long-term rate of interest.
Apartments, given the short duration of typical leases, are uniquely positioned to re-price their rents to keep up with inflation. While the consumer price index rose 7.1 percent year over year in 2021 and 7.9 percent as of February 2022, rents for professionally managed apartments tracked by RealPage rose by an even greater 10.5 percent year-over-year for new leases and 8.1 percent for renewals as of November 2021.
If higher borrowing costs are offset by higher growth rates in rent and NOI, cap rates should remain unchanged. In other words, cap rates can be thought of more as a real rate of return, which are only affected by changes to the real interest rate.
Impact of Rent Growth on Prices
Still, apartment rent growth has lagged inflation in every market or unit type over the past two years. For instance, inflation (measured by changes in CPI) averaged 8.6 percent between 2020 and 2022, while rents tracked by RealPage rose an average of just 2.6 percent in Los Angeles, 2.2 percent in Boston, 2.1 percent in Seattle and 1.8 percent in Washington, D.C.
Rents declined an average of 0.2 percent per year in New York and 6.3 percent per year in San Francisco during this two-year period. And rent growth over the past two years was even lower among one-bedroom and studio apartments.
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