One Man’s Ceiling is Another Man’s Floor – Multifamily Relative Value in a Rising Interest Rate Environment
It’s no secret that multifamily assets enjoy the lowest return volatility and strong cash flow characteristics versus other commercial real estate asset classes. Single Family Rental (SFR) portfolios offer another path to multifamily asset exposure on a relative value basis. Office, industrial and retail cap rates generally trade in a constrained range versus one another while hospitality cap rates are materially higher and more volatile.
On a national basis, average multifamily cap rates are in the context of historical lows at ~5.50% according to CBRE Research. Class A assets in major metropolitan areas trade at cap rates less than 5.00% and in select cases less than 4.00%.
July 2016 saw the 10-year U.S. Treasury (UST) note yield at 1.38%. As I write this research note the 10-yr UST yield is 3.12%, lower in yield from a recent high of ~3.25%. So in a little more than 2 years, the 10-year UST yield increased ~175 basis points. The yield has almost doubled. That fact is very significant.
Meanwhile multifamily cap rates are largely unchanged. Thus the 412 basis point cap rate / 10-year UST spread of 2016 has compressed to 238 basis points. According to the NAIC, from the mid-1980’s to present the multifamily cap rate spread averaged ~231 basis points.
In a broad sense, the market has cycled from a period of abnormally high returns to an environment of normalized multifamily risk premium. This leads to lower cash on cash returns for any given project. Keep in mind that cap rates are largely unchanged. Given that the rising interest rate trend is likely to continue, investors are well served by securing financing sooner rather than later. The generalized formula for cash ROE is
Cap Rate + (Cap Rate – Cost of Debt) * (LTV / (1 – LTV)).
Obviously the takeaway from the above formula is to not chase leverage in an environment where cap rate spreads are compressing. Focus instead on macro and fundamental relative value through market selection and property class analysis.
Where does one find relative value in this market?
The answer is decidedly not Class A assets in the top 50 MSA’s. While multifamily vacancy rates edged higher recently, vacancy rates remain in the context of historical lows. Class A new supply dominates units delivered to tenants over the last few years. This is part of the market dialog from many points of few: low cap rates, affordability, access and land prices to name a few.
That said, Class B and Class C multifamily properties with less than 100 doors in communities surrounding metro areas and in secondary markets provide relative value. In both value-add and stabilized cases, their higher cap rates and opportunity in increase NOI through asset repositioning and effective property management create attractive investment opportunities. Taking advantage of this market dynamic and locking in one’s financing before rates trend even higher solidifies the cash-on-cash return for a project.