When the COVID-19 pandemic hit during the spring of 2020, the multifamily real estate market faced a seemingly daunting array of challenges. The greatest of these challenges was the threat of a sudden and sharp collapse of rent collections and a spike in vacancies, fueled by surging unemployment and a collapse in consumer demand. To be sure, the dramatic actions taken by the U.S. government did much to soften the impact, but it was still severe in many regions.
Despite the onslaught of the pandemic-induced recession, multifamily property values have continued to outperform most other property types and have actually accelerated. Investor demand has been especially strong, cap rates have been driven to historic lows and there are bidding wars for institutional quality assets, especially in secondary markets.
As the chart below illustrates, we have seen a sustained increase in apartment values since they bottomed in July 2009. Appreciation has continued at a strong pace despite a significant increase in interest rates since they were at their lowest in July 2020, and while the cap-rate spread (as indicated by the green shaded bars on the chart) has narrowed, it still remains historically high.
One of the key drivers since 2009 has been the sustained historically low interest rate environment. Since the depths of the Great Recession, the bellwether 10-year Treasury Security has steadily trended downwards from a high of 3.22 percent in October 2018 to about 1.50 percent just before the pandemic. The yield dropped to a historic low of 0.55 percent last July, and recently settled at about 1.58 percent. Meanwhile, multifamily values just kept rising, seemingly impervious to the volatile interest rate environment.
Multifamily Valuation Trends
One concern that investors may have is that the current market trend will be hindered by rising interest rates. While market cap rates generally tend to increase during periods of rising interest rates, there is no direct correlation. Rising interest rates can be a factor, especially if mortgage interest rates rise above cap rates (so-called “negative leverage”). Cap rates, however, are primarily driven by supply/demand and risk/return considerations.
In the current rate environment, there is still positive leverage—for the most part cap rates are higher than financing rates. Investment capital is pouring into apartments, which are experiencing strong income growth. Many properties are trading at record low cap rates on the expectation that rent and occupancy growth will continue to rebound strongly from pandemic lows. Additionally, there is tremendous loan demand from the Agencies, life insurance companies, and debt funds in particular.
These observations would tend to support the conclusion that multifamily property values will likely be insulated from rising interest rates, at least over the near term. Also, the underlying fundamentals are excellent and capital flows are strong. Therefore, it is reasonable to project continued strong performance in the foreseeable future.
Jay Maddox is a principal in Avison Young’s Capital Markets Group.