Just when we think the apartment market can’t get any stronger, we hit the equivalent of 88 miles per hour and see cap rates reaching a new record-low level. We observe that the mean cap rate, illustrated by the dark blue line in the chart, declined by 10 basis points to 5.7% during the second quarter. The market continues to reach record-low levels and the average commercial real estate cap rate has now been below 6% for all of 2016.
It remains remarkable that this far into an economic expansion that investors are willing to pay such a premium for apartment properties. Certainly, the low-yield environment around the world plays a big role, especially given the relative strength that we have observed in apartment fundamentals. But ultimately what this shows is that investors, despite new supply growth, continue to be bullish on the apartment sector, even if only on a relative-value basis.
As the mean cap rate has continued to fall over time, it is unsurprisingly pulling down the 12-month-rolling cap rate, depicted as the red line in the graph. Due to the strong downward trend in the market, that metric has now fallen below 6% for the first time ever, reaching 5.9% during the second quarter. This demonstrates that these sub-6% cap rates are a longer-term, durable phenomenon and not a one-quarter anomaly.
The downward trend in cap rates for multifamily properties is also dragging down the historical long-term average cap rate, shown as the dashed line in the chart, which has now fallen to 6.5%.
The environment remains ideal for apartment cap rates to remain at or near historically low levels and possibly fall even further. Nothing fundamental has changed between this quarter and last quarter to alter that view. While hearing anecdotally from clients that they are starting to balk at such high apartment prices, that looks more like the exception these days based on the cap rates for properties in the market that are actually trading.
Apartment Cap Rates Drop to Historically Low 5.6% Time to Sell
In a show of strength, cap rates reached new historically low levels during the first quarter. We observe that the mean cap rate, illustrated by the dark blue line in the chart, declined by 40 basis points to 5.6% during the first quarter. As mentioned, this is a record low.
Moreover, it is first time that we have observed a mean cap rate less than 6%. It is important to emphasize that this is the mean cap rate for properties that actually traded during the quarter, not the cap rate for all properties. Nonetheless, a 40-basis-point decline is a surprise. And while I will always caution reading too much into one quarter’s worth of data, this development is noteworthy.
Not only are we at a relatively late juncture for apartments (measured by both the fundamentals space market and capital market cycles), but we haven’t seen a movement nearly this strong since the market was climbing out of the recession; and of course such a strong downward movement should be expected during such an environment. The strong downward movement is far rarer at this relatively late stage of the game.
This downward trend continues to pull down the 12-month-rolling cap rate, depicted as the red line in the graph. That metric now stands at a scant 6%, also a record low for apartment cap rates since Reis has been tracking the market. Like with most data points, a little context is important. If you look at the dashed, light-blue line in the graph above, you can see the average 12-month rolling cap rate since 2005 is 6.6%. That means that the current 12-month rolling cap rate is now 60 basis points below the average. While that is significant, it is not egregious. And as we have discussed in past capital markets briefings, this is a consequence of continued low interest rates, not of irrational exuberance. And while it is difficult to envision apartments cap rates continuing to compress at a rate anything like what transpired during the first quarter, we should also not expect cap rates to expand much in the near -term based on the outlook for apartment fundamentals. Therefore, cap rates are likely to remain in the high-5% to low-6% range over the next year or so.
Source: REIS Ryan Severino on Jun 1, 2016
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Strong Profit Growth Keeps Apartments as Favored Property Type
Apartment property performance in 2015 continued to outperform even the strong performance seen in 2014 and 2013, according to the latest financial data collected on thousands of multifamily complexes. And the net operating income performance for the property sector may still head higher.
The combined 2015 net operating income at nearly 5,900 conventional multifamily complexes reporting year-end numbers totaled $8.16 billion, according to Fannie Mae and Freddie Mac data collected through April and analyzed by CoStar Group. Those complexes contained 1.16 million apartment units — consequently representing NOI per unit of $7,044.
CoStar analyzed property-level data on collateral backing loans securitized by Freddie Mac and Fannie Mae. Since conventional multifamily properties make up the bulk of that collateral, student, senior and manufactured housing was excluded from this analysis.
For the nearly 4,800 units that reported full-year NOIs for the last two consecutive years, NOI/unit increased 5.2% year over year. Those properties represented nearly 914,000 units. The 2015 increase outpaced growth in 2014 and 2013 of 4.09% and 5.01%, respectively, according to separate research conducted by Wells Fargo Securities.
Multifamily properties securitized in CMBS conduit offerings appeared to be faring even better posting year-over-year NOI gains of 7%, according to Wells Fargo Securities.
Priciest Properties Appear to Lead Increase
The year-over-year increase seems to be a top-down phenomenon. For multifamily properties with 2015 NOI/unit of $5,000 or more (about 607,400 units), the annual NOI increase came in at an average of 5.9%, according to CoStar analysis.
In properties where the 2015 NOI/unit was anything less than $5,000 (about 310,300 units), the annual NOI increase came in at an average of 4.4%.
By apartment complex size, the largest complexes of more than 500 units posted the lowest increase in NOI of just 4%. Apartment complexes ranging from 100 to 500 units appeared to be a ‘sweet spot’ for NOI, posting NOI increases of 6.1%. Smaller complexes of less than 100 units posted NOI of 4.9%.
NOI decreases were reported for 216,930 units, which account for about 24% of units reporting NOIs for the last two years. And only five properties totaling 433 units reported NOI losses for 2015.
Occupancy Flattened Out
The average annual physical occupancy for the reporting properties was static coming in at 94.3% for both 2015 and 2014.
In total, nearly 40% of the properties reporting physical occupancy for the last two consecutive years reported decreases in occupancy. Those properties represented 402,838 units, about 44% of units.
Notably, however, profitability continued to grow even as occupancy declined. Net operating incomes shrunk in less than 30% of the properties reporting occupancy declines. Overall NOIs in those properties grew year over year by $128 million.
Also, judging by recent performance at the newly opened properties, there is still strong demand for multifamily units. Of the properties reporting, 205 of them containing 7,585 units were newly constructed in 2014. At year-end 2015, their average occupancy was 94.2%. Additionally, properties delivered in 2013 were reporting 2015 occupancy of 94.7%.
“The occupancy and NOI findings from Freddie and Fannie are not surprising, as they are consistent with what we’ve experienced within our own multifamily portfolio,” said Yvana Rizzo, senior vice president of asset management for Resource Real Estate in Philadelphia, which owns and manages a portfolio of real estate investments with an aggregate value in excess of $3 billion, including approximately 25,000 apartment units.
“NOI growth has been driven by a top line increase in rents, which is simply a result of the powerful supply/demand dynamic in this sector,” Rizzo added. “We’re still very optimistic about current state of the apartment market and the favorable imbalance of demand over supply. This trend is being driven by a shift in people’s preference towards renting over homeownership.”
High rental demand is coming from Millennials, the middle-class workforce and retiring boomers, she said.
Multifamily Remains Q1 Growth Leader
Estimating NOI based on changes in rent and estimated expenses for the entire apartment sector nationally, CoStar Portfolio Strategy, the company’s analytics group, is projecting that NOI growth for the multifamily sector this year will outpace last year.
Actual quarterly NOI growth in the first quarter of 2016 came in at 2.94%. CoStar is projecting that NOI will increase in each of the next four quarters peaking at 5.22% in the first quarter of next year. This would be the best performing period on record for apartments since the last market peak in 2007.
NOI growth is expected to begin to taper off quarterly in the second quarter of 2017 and decline slightly each quarter through 2020, the last year of the current projection.
Apartment property price growth has also been strong. CoStar’s April 2016 Multifamily Repeat Sale Index expanded 0.8% in the first quarter of 2016 and 9.9% in the 12-month period ending in March 2016. These were the strongest quarterly and annual rates among the four major property types.
Multifamily remains the only U.S. property index to have regained its pre-recession peak, ending the first quarter of 2016 18.8% above its previous high level in 2007. Notably, the CCRSI’s Prime Multifamily Metros Index has skyrocketed to 44.9% above 2007 levels.
While an unprecedented pipeline of new supply is beginning to exert pressure on multifamily fundamentals nationally, vacancy rates remained relatively tight at 4.4% in the first quarter of 2016.
Softening on the Horizon
Nationally, the outlook for the multifamily sector for the rest of this year is for some softening of rent fundamentals, according to Fannie Mae economists.
Rent growth has been exceptionally strong since 2011. It has remained in the 3% range over the past two years. The expectation for 2016 is that rent growth will once again be positive, but that it will ease slightly into the 2.5% to 3% range due mainly to a large amount of new supply should come online in 2016.
Fannie Mae expects much of the new supply will be concentrated in about 12 metros. There is approximately 330,000 apartment units expected to be constructed this year, according to CoStar data. About 48% of those units are expected to be delivered in these 12 markets:
Market Name — Number of Units
Houston — 27,553
Dallas/Ft Worth — 21,038
Washington, DC — 12,310
Long Island — 11,806
Atlanta — 10,282
Northern New Jersey — 10,004
South Florida — 9,957
Austin — 9,696
Charlotte — 8,806
Chicago — 8,535
Denver — 8,488
Nashville — 7,741
“As an investment, we feel multifamily makes sense as long as investors are selective and focus on the right product in the right markets,” Resource’s Rizzo said. “We think the best opportunities are in the older, existing Class B communities that are ripe for rehabilitation. Ideally they are located in suburban communities with employment growth and strong schools.”
“Not only are these desirable areas to live but they are places where it is extremely difficult to build new supply. High-end, Class A, luxury apartments make up the majority of new construction. They are expensive and tend to be located in urban areas,” she added.
Q3 2015 Apartment Trends – After holding steady at 4.2 percent for the first two quarters of 2015, the national vacancy rate rose by 10 basis points to 4.3 percent during the third quarter. We have been expecting that vacancies would rise given the amount of new supply coming online. Vacancies have been bouncing around at these levels for the last two years, with a similar 10 basis point increase in the third quarter of 2014 (only to fall once again at the start of 2015). Overall, market fundamentals remain tight.
Asking and effective rent growth was very impressive, rising by 1.4 and 1.5 percent respectively. On a year-over-year basis, asking rents rose by 4.2 percent, and effective rents rose by 4.3 percent. These are robust figures, strong enough to fuel the hopes of optimists banking on resilient rent growth even if occupancies stay flat or deteriorate. For perspective, apartment rent growth has not been this strong (on a year-over-year basis) since 2007.
Supply and Demand Trends
Over 40,000 units were brought to market during the third quarter, which is less than the second quarter figure; yet – vacancies rose. It is only in retrospect that we will be able to proclaim this third quarter rise in vacancy as a true inflection point, but if the market is showing signs of being unable to absorb 40,000 units of new construction, what will happen when close to 100,000 units come online over the next quarter or two, as our latest projections show? Fundamentals remain tight, but it will be interesting to see where the intersection of demand and supply plays out over the next few quarters.
We expect national vacancies to rise modestly over the next few years, but we’re not very worried about the multifamily sector if these projections come to pass – vacancies will be in the low to mid 5s by 2019, which doesn’t portend lean times ahead.