Cap Rates to Rise, Model Predicts

Lew Sichelman

Are multifamily capitalization rates destined to rise further?

Yes, according to a model developed by the First American Financial Corp. that simulates cap rates based on various transaction volumes.

“No matter how you cut it, multifamily cap rates seem likely to rise further,” wrote Xander Snyder, the firm’s senior commercial real estate economist, in a recent blog post.

If the simulator is on point, it would mean a continuation of the upward march in cap rates, one that has been driven, Snyder noted, by a dearth of multifamily properties changing hands from one investor to another.

Cap rates have increased for the last three quarters, the first time that’s happened since the Great  Recession in 2008. Investors are requiring higher yields, according to Snyder, because transaction volumes have been “muted.”

The decline in property sales not only follows the “frenzied pace” of transactions during the pandemic but also “remains depressed” relative to pre-pandemic levels, Snyder observed. And with lingering economic uncertainty ahead, it is difficult to project what the next few months hold for the sector.

First American’s Multifamily Potential Cap Rate model simulates what cap rates would be under various transaction volume scenarios.

For example, if the volume of deals reverted to pre-pandemic levels and remained at that level for several quarters, the model indicates the cap rate would be 5.1 percent. That’s up from 4.9 percent in this year’s second quarter.

But if the economy limps into a recession, the cap rate would go even higher, to 5.6 percent, the model predicts. A recession would impact the market in several ways—through tighter credit, less leasing demand and a preference on the part of investors for less risky assets, the First American economist warned.

Say, however, that volumes remained at second quarter levels, which were 34 percent below pre-pandemic levels and stayed at that level for several months. In that case, the model predicts cap rates would increase to 5.6 percent without a recession. But with an economic downturn, it suggests the rate would hit 5.9 percent.

The model’s downside scenario, then, is a 100 basis point increase in cap rates. But if transaction volumes return to pre-pandemic levels and stabilize at that point, only a 20 basis point increase is likely.

Either way, though, First Am’s sensitivity analysis predicts an increase in cap rates lies ahead.

Other cap rate predictions

Meanwhile, Freddie Mac’s latest forecast calls for a contraction in multifamily mortgage volume to $370 billion for 2023 as a whole.

Performance has been somewhat weaker so far this year, according to Sara Hoffman, director of multifamily research at Freddie Mac. Nevertheless, she has begun to see a return to more normal patterns.

The government sponsored enterprise sees positive demand and modest growth ahead. But because market fundamentals are slightly below long-term averages, Hoffman warned, the market will seem slow when compared to the years prior to the pandemic.

Freddie Mac’s Multifamily 2023 Midyear Outlook predicts the strong labor market will support household formations, which, in turn, will support the apartment market through the year—“but at relatively modest levels.” And over the long term, the sector will continue to be propelled by an overall housing shortage, expensive for-sale housing and favorable demographics.

But because of a heightened degree of economic uncertainty and the elevated and somewhat volatile interest rate environment, multifamily transaction volume has slowed, the report points out.

“The upward pressure on cap rates due to the higher 10-Year Treasury rate has put downward pressure on property prices,” according to the Outlook. “Additionally, given the higher interest rates and slowing fundamentals, buyers and sellers are having a hard time agreeing on asset value.”

As a result, Freddie Mac expects originations in 2023 to experience a contraction to $370 billion, a decline of 17 percent from 2022.