April 20, 2018

Apartment Valuations Test New Cycle Extreme, Despite Visible Risks

Every month, we survey private multi-family operators, developers, brokers and lenders to assess fundamental trends across the sector. Our survey covers roughly 1.5 million institutional-quality units and developers that accounted for 9% of 2017 multi-family starts. Below, we summarize several data points that relate to the transaction market, which we believe reflects elevated valuation risk considering the fundamental backdrop.

First, once a quarter we ask executives whether they would “buy”, “build”, or “sell” assets in the current environment if given only one choice. For 1Q18, 68% opted for “sell”, up from 64% in 4Q17 and at the high end of the 37-72% range posted since we started the question in 3Q12. The predominant rationale for this answer was stretched valuations, a heavy pipeline of supply and interest rate uncertainty. Similarly, only 9% of contacts were willing buyers in 1Q18, down from 15% last quarter to the lowest share over the course of our survey.

To put valuations into perspective, these same survey participants estimated class-A cap rates in their markets of operations at 4.55%, on average, ranging from sub-4.00% in San Francisco, the New York metro and Los Angeles to over 5.00% in Las Vegas, Jacksonville and Baltimore. The aggregate cap rate was the lowest since at least 1Q12, marginally surpassing the prior trough of 4.65% in 2Q16 and 4Q17.

The amazing aspect from our perspective is that cap rates compressed in 1Q18, despite substantial upward movement in the 10-year Treasury yield, which we believe is an appropriate benchmark to analyze perceived risk and opportunity. The spread between these two yield measures averaged 180 basis points in 1Q18, down from 230 basis points in 4Q17. That is the third largest quarterly shift in the spread over the last six years, setting a new low.

The multi-family backdrop faces substantial new supply with the pipeline under construction near the highest level since 1974, interest rate concerns are pronounced again and rent growth has compressed given later cycle dynamics. This all should blend into a more cautious stance on valuation, but the opposite has been true.

To be sure, the capital appetite for multi-family assets is very strong, particularly for class-B projects where yields are higher and a value-add remodel story is present. Many of our contacts note that this “wall of capital” far exceeds the availability of projects for sale. However, there is no denying, in our opinion, that valuation is more stretched than at any point in the cycle thus far, unless, rent growth reaccelerates notably and the risk of higher interest rates proves benign.

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