Is There an Apartment Market Bubble?

By Keat Foong, Executive Editor

MHN: In many of the top U.S. markets, apartment pricing appears to have returned to, or be close to, peak levels achieved in 2007. In certain cases, cap rates are once again sub-4 percent. Is there a possibility of a bubble developing in multifamily real estate driven by the low cost of capital, low yields in alternative investments, aggressive projections of apartment incomes in valuation and/or any other factors?

Generally, I do not see a bubble in the for-rent apartment housing market at this time, but it is on the horizon with arrival dependent upon the relationships between supply and demand and interest and cap rates for each market. This is really nothing new; it is, after all, a cyclical business.

The strong apartment market fundamentals over the past two years, when coupled with low interest and cap rates, have resulted in values improving substantially from the trough. While this has aided operators, investors and lenders in recouping most of their losses from the downturn, it has also stimulated interest in the asset class, resulting in prices being bid up for existing properties and making development more financially attractive. This is a good thing.

However, this success over time often results in excess supply financed with higher levels of low interest-rate debt so that when supply eventually exceeds demand and interest and cap rates inevitably rise, the value of the projects fall to as much as the debt or lower, potentially creating significant losses for the stakeholders if they have to sell or refinance a property. This outcome can be mitigated. In order to diminish this outcome, the stakeholders are banking on strong revenue growth, particularly in the early years of the holding period, and similar going-in and going-out cap rates. (We expect the U. S. apartment market to remain strong until 2014 when supply exceeds demand, slowing down rent growth to 4.0 percent in 2014 and 3.0 percent in 2015 from a peak of 5.5 percent in 2012. )

I think a good part of the interest and cap rate risk can be constrained by borrowers and lenders if they do the following: 1. Limit mortgage loans to 75 percent to 80 percent loan-to-cost and/or loan-to-value ratios to create a cushion when the down turn occurs; 2. Require debt service coverage ratios of at least 1.20 to increase the borrower’s likelihood of making the mortgage payments when revenues decline; 3. Minimize the number of projects financed with interest-only loans; require loans to amortize, further reducing leverage; 4. Make loans with longer maturities at lower interest rates to ride out the trough; 5. Work with experienced and financially strong borrowers; 6. Calculate property values using going-out cap rates based upon reasonable estimates of the risk premium and forward 10-year bond yield; 7. Diversify loans by borrower, geography (markets and submarkets) and product to limit risk; 8. Base revenue growth upon forecasts taking into account that supply will eventually exceed demand, resulting in slower revenue growth and lower occupancy rates.

Ronald G. Johnsey
President, AxioMetrics Inc.

We do not currently see a bubble in apartment values. If our forecasts for apartment rent growth prove accurate—and we forecast positive, but decelerating rent growth over the next several years—apartment values look to be in proximity of fair value, maybe even a little cheap. Our main benchmark is the fixed income market. Unlevered IRR premiums to 10-year Treasuries, BAA corporates and high-yield bonds (a case can be made to compare return hurdles to any three of these indices) are all in-line or larger than historical averages. If we are in a bond bubble—and we don’t pretend to be smart enough to answer that question—then yes, apartment asset values may be inflated. However, if such proves to be the reality, a lot of other asset classes may also be inflated, not just apartments or commercial real estate in general.

Ray Huang, Residential Sector Analyst
Green Street Advisors Inc., an independent real estate research firm.

Apartment buildings, particularly those in core markets, are selling at high prices now. We are seeing deals consummated at capitalization rates in the low 4’s—a historic low. Have investors taken leaves of their senses? Perhaps.

Jim Clayton has a nice paper (http://www.cornerstoneadvisers.com) that shows that the average cap rate between 1990 and 2008 had a spread of 262 basis points over Treasury yields. The 10-year Treasury closed at 2.31 percent at the end of this week.  If long-term spreads give us a sense of the risk premium for real estate, this suggests cap rates should be more like 5 percent instead of 4 percent—unless we can reasonably expect rents to rise faster than normal for a period of several years. I am not sure we can in fact expect that.

To me, the principal driver of low cap rates is the attractive financing being provided by the GSEs. This allows for healthy cash flows, even in the presence of low cap rates. The problem will arise when GSE multifamily loans come due. If rates rise in the next five to 10 years and rent growth is disappointing, maturity defaults may come back to haunt us.

Richard K. Green, Lusk Chair in Real Estate, Professor, Price School of Public Policy and Marshall School of Business, University of Southern California