What rising interest rates mean for apartment cap rates
With inflation and interest rates on the rise, following the Federal Reserve’s first rate hike in three years, many multi-family investors are concerned about the impact these dual forces will have on apartment cap rates. , which have tended to decline over the past twenty years.
In the fourth quarter of 2021, apartment cap rates hit a low of 4.7%, down 30 basis points from a year earlier, according to apartment transaction data tracked by Real Capital Analytics that the National Multifamily Housing Council cited it in a recent article.
Just “aggressive” enough
Overly aggressive interest rate hikes could dim the outlook for economic growth, negatively impacting property values and pushing up cap rates, the NMHC said. Cap rates could also face upward pressure in markets with reduced rental growth projections, as seen in the San Francisco and New York markets over the past five years.
Yet apartment cap rates are fundamentally a real rate of return that should only be affected by changes in the real interest rate, the association said, noting that “apartments, given the short-term nature terms of their leases, are uniquely positioned to simply revalue their rents during periods of inflation to offset rising nominal interest rates.The NMHC points out that while the 10-year Treasury has already risen slightly, the market apartments continues to benefit from historically high occupancy rates and rental growth, leading to a further decline in capitalization rates.
Additionally, with apartment trading volume at record highs, investors may simply be willing to accept a lower premium for owning apartments.
NMHC went into more detail on why nominal interest rates may have less of an impact on capitalization rates than one might expect.
Low correlation between nominal interest rates and cap rates
Interest rates influence borrowing costs for investors. For decades, falling long-term interest rates have supported apartment values, driving down capitalization rates.
Still, the correlation between long-term interest rates (represented by 10-year Treasury yields) and apartment cap rates isn’t particularly strong, NMHC said. For example, the market yield on 10-year Treasury bills fell from 3.6% in the 2nd quarter of 2003 to 5.1% in the 2nd quarter of 2006, during which time apartment cap rates fell by 7 .6% to 6.4%.
Ten-year yields also increased from 1.6% to 3% between Q3 2016 and Q4 2018, while cap rates fell slightly from 5.6% to 5.5% . And, most recently, 10-year rates fell from 0.7% in Q3 2020 to 1.5% in Q4 2021, while apartment cap rates fell to record lows.
Cap rates as real rate of return
The context surrounding rising nominal interest rates is also important. Since the most recent hike in 10-year Treasury rates was simply a response to higher inflation, there hasn’t been much change in the real long-term interest rate.
Apartments, given the short duration of typical leases, are in a unique position to reassess their rents to keep up with inflation. While the consumer price index rose 7.1% year-over-year in 2021 and 7.9% in February 2022, rents for apartments managed by professionals tracked by RealPage rose still more than 10.5% year-on-year for new leases and 8.1% for renewals as of November 2021.
If higher borrowing costs are offset by higher growth rates in rents and RNE, capitalization rates should remain unchanged. In other words, cap rates can be thought of more as a real rate of return, which is only affected by changes in the real interest rate.
Impact of rental growth on prices
Yet apartment rent growth has been below inflation in all markets or unit types over the past two years. For example, inflation (measured by changes in the CPI) averaged 8.6% between 2020 and 2022, while rents tracked by RealPage only increased an average of 2.6% in Los Angeles. Angeles, 2.2% in Boston, 2.1% in Seattle and 1.8% in Washington. CC
Rents fell an average of 0.2% per year in New York and 6.3% per year in San Francisco during this two-year period. And rent growth over the past two years has been even weaker for one-bedroom apartments and bachelor apartments.