Cap rates have been on a steady downward trend for the past twenty years. While the great recession saw a temporary bump in cap rates, even that weight behind that momentous historical event could not hold off the decline in cap rates for long. What does this mean for real estate investors? For us, it means that class A luxury properties have become much more attractive as options for investment than they previously were.
Cap Rate Compression Lowers Yield
As cap rates go down, you are getting less return for each dollar of the acquisition price. Cap rates can go down for a number of different reasons. In our Why We Target Class B and C Properties for Multifamily Investing and How to Choose Recession Resistant Multifamily Investments articles, we discussed why we typically target value-add class B and C properties. This is still true and is one of the main legs of our investment strategy.
That said, you need to always keep your ear to the ground and watch out for any market forces that shift the investment environment. One such force that has become increasingly prominent is cap rate compression. Cap rate compression simply means that the cap rates are going down (being compressed).
Why do cap rates go down? There are many factors that influence cap rates, but the intangible, traditional reasons people might point to are that the market itself improved. As a market becomes more desirable and is viewed as less risky, cap rates will naturally compress as more investors compete for property purchases. What about if cap rates are being compressed across the board, rather than simply in one market versus another? That’s when you need to start looking at other factors to explain the drop, which we’ll get to below.
Assuming no other factors are involved, when cap rates compress, it simply means that you have to pay more money to achieve the same level of yield you would have previously. The orthodox school of investing will tell you that this typically squeezes out those investors who are looking to use leverage through debt financing for their purchases.
When the yield for purchasing the asset is less than the market interest rate, using leverage to purchase real estate stops making sense. As the vast majority of investors use leverage for real estate purchases, this situation gums up the system and allows only the rare cash buyer to make an investment.
The Orthodox View is Not Relevant in Today’s Situation
While the above investment wisdom is indeed true, the problem lies in the fact that it’s simply not relevant to the cap rate compression we are experiencing today. That’s because cap rates are chasing falling interest rates, rather than cap rates dipping below interest rates. The interest rates falling are the impetus of the cap rates compressing, rather than the two being isolated variables.
Due to historically low interest rates, debt financing has never been more attractive. This is essentially the opposite scenario that people have traditionally thought of in the example I provided above. In isolated examples, cap rate compression can and has led to yield falling below market interest rates, especially in expensive primary coastal markets.
Yet it also makes sense that, when looking at things from a macro-perspective, an environment with falling interest rates will also lead to compressed cap rates. As we mentioned above, the vast majority of real estate purchases are made using leverage. If interest rates go down, it means that your levered yield increases.
This is arguably more important than the property’s NOI, especially if you’re the general partner in a real estate syndication. You’re going to be using a combination of debt financing and equity investments from your limited partner investor base.
Your levered yield is really all that matters because that is where your investors’ returns are derived from, as well as your own. You won’t mind a very low cap rate purchase if the yield is significant enough to pay your investors a handsome IRR (internal rate of return).
Most people do not have time to be an active landlord and prefer to invest in real estate passively, which has made real estate syndications one of the most popular forms of investment today. That’s why it’s important to view this question from the perspective of such a common and popular investment vehicle.
Indeed, the orthodox view of cap rate compression with all-cash buyers being a significant factor in the marketplace is perhaps a bit too theoretical. The main way the average investor becomes involved in these large commercial transactions is through a syndication. For more information on that topic, please check out our What is a Real Estate Syndication for Multifamily Investing? Article for additional information.
If interest rates reach historic lows as they are today, this means that pretty much every investor will be willing to pay more for the property than they had been previously. The cost of capital being so much lower has a tremendous effect on your levered return. This makes those lower cap rates “possible” and makes returns attractive at a cap rate far below what one might expect.
Cap Rates Chase Interest Rates
It makes sense, then, that cap rates will move in accordance with interest rates. Take a look at this chart that tracks cap rate movement with the 10-year treasury notes, which are the benchmark that guides all other interest rates:
Stated another way, investors care less about a low cap rate when they can borrow money for less interest. In fact, if interest rates are competitive enough, investors could even begin to realize greater levered yields during a period of cap rate compression.
I believe that it takes some time for movements in interest rates to be reflected in market cap rates. This means that if you’re nimble you can benefit from a lower interest rate environment before the cap rates have compressed fully to reflect the change in the interest rate market.
Cap Rate Compression Makes Luxury Class A More Attractive
Another thing to keep in mind when we’re discussing cap rate compression is that it doesn’t compress on a 1-to-1 basis across all asset classes. What we’ve noticed in many of our target markets are compression seems to slow down as you hit lower and lower cap rates.
The end result of this is that luxury class A properties, which generally cannot provide a competitive yield when compared to value-add class B and C properties, become much more competitive. We’ll illustrate this by providing an example based on real deals we’ve been sent by our broker network:
Let’s say you’re operating within a market where class A properties typically traded at a 5% cap and class B properties typically trade at a 6.25% cap. Let’s say we’re operating in this market for a few years, and now some time has passed and interest rates have fallen. We’re now in an environment where cap rates are being compressed due to falling interest rates.
You would think that the cap rates would compress equally across all classes of multifamily with falling interest rates, but that’s not what we’re seeing. There’s no discernible pattern or rule of thumb as to what’s at work, but what we’ve observed is that typically class A properties do not experience compression as severely as class B and C properties. For this example, we might see the class A property compress to a 4.5% cap, but the class B property drop all the way to a 5% cap.
My theory is that this has to do with some combination of the already low operational risk seen with class A properties and what is usually a more attractive return from class B and C deals. Since class A properties are newer and located in low-risk areas, the “reduced risk” from a higher levered yield is not as significant for other multifamily classes.
Furthermore, value-add B and C properties have a greater yield potential in most situations. When interest rates fall, investors remain focused on this strategy and negotiations become more competitive due to the lower cost of capital. More investors compete for these properties than would normally be the case, causing accelerated cap rate compression.
As you might imagine, it becomes difficult to turn a blind eye to class A properties when the cap rate spread between class A and B is so minimal. It starts to become objectively silly not to consider and incorporate class A purchases for your investment portfolio. For this reason, we are actively analyzing class A opportunities within this current interest rate environment.
So what’s the future for interest rates and cap rates? Visual Capitalist recently published a fascinating article which tracked interest rates over the past seven hundred years. The findings show the interest rates are on a centuries-long decline.
My speculation is that this trend will continue and it has to do with the evolution of the global economy. As economies become more productive, more people have access to capital, and there is more capital available to lend. A loan today isn’t as valuable as it was hundreds of years ago.
While that’s just my pet theory, what’s indisputable is the continual decline of interest rates. As interest rates fall, investments using debt financing as leverage become more attractive. This allows levered investors to pay more and receive the same yield they had previously and creates a more competitive environment that compresses cap rates. Paying close attention to the spread in cap rates is important. As cap rates compress, you may find yourself, as we are, looking more and more at class A deals.