Just this past week the FOMC raised its target for the federal funds rate another 25 bps, currently targeting a lending rate between financial institutions of 4.5% to 4.75%. This is a clear sign that the average cost of capital is more than 5%.
Yet, this is far from the only factor on the minds of apartment buyers as they assess what to pay when buying an apartment building.
Sizable reductions in tech workforces in West Coast cities make daily headlines. San Francisco/Silicon Valley is hardest hit, yet Seattle/Bellevue/Redmond is not immune.
Nearly every news source argues that a recession is nigh – quoting that every battle with inflation in recent memory resulted in either a recession or rapid economic slowdown.
Yet all such analytical support NOT to pay “market pricing” when buying an apartment building right now is shortsighted.
If only there was a magic formula to understand what to pay for an apartment building!
In the past it’s been quite clear – just take what occurred the last 3 to 5 years and pretend those trends will repeat for the next 3 to 5 years.
In today’s economic/interest rate environment, not so fast!
With proclaimed economic uncertainty for the next 12 to 24 months, how does one decide to sit on the bench or jump into the fray as a buyer?
The following analysis explores 3 concerns standing in the way of markets being made:
- Where is pricing today?
- What are buyers (your competitors) doing?
- What is going to happen?
Where is Pricing Today
On Friday (February 10th) we’ll publish our 10th Annual Market Study analyzing 340 apartment sales in the Puget Sound region during 2022. However, looking at average cap rates for those sales versus the previous 10 years of sales provides little guidance into “todays” pricing.
Puget Sound Sales Trends
2005 – 2022
Source: Simon | Anderson Multifamily Team
Unprecedented rate hikes (7 of ‘em) rocked the market in 2022 – as has concerns over a cooling economy. Both are massively influencing buyer underwriting.
In times when capital markets are less volatile, sales comparables from a previous quarter (or two) are illustrative of current pricing, yet the 2nd half of 2022 presented one of the strangest periods in recent memory, with only 22% of all annual closings occurring in the fourth quarter.
Additionally, comparing the 10-year treasury rate (which doubled from January to October 2022) to monthly cap rates provides scant guidance.
2022 Apartment Sales by Month
Monthly Cap Rates versus 10 Year Treasury
Source: Simon | Anderson Multifamily Team; Federal Reserve
Adding to the opacity, institutional sales – which are most comparable given similarities between each sale – were nothing short of anemic during the last 6 months. From July to December 2022, only 15 sales occurred of buildings greater than 150 units, representing less than 5% of all sales activity in 2022.
Analyzing sales by submarket and county still provides little pricing guidance.
2022 Apartment Sales – Capitalization Rates
2017 to 2022 Cap Rates by County
Source: Simon | Anderson Multifamily Team
The tenor of buyers is pithily summarized in the following exhortation, “I’d buy a 5”.
Simply put, the market is demanding neutral or positive leverage based on actual, in-place income (at closing or highly predictably thereafter).
Sellers have not yet received – or acknowledged – the memo.
Clutching closely to sales comparable of yesteryear (with some accommodation to rising interest rates), sellers seem complicit on pricing discounts no greater than sales equating to 4.5% cap rates.
What are Buyers Doing?
In the transactional game of apartment sales, it takes two to tango, so what are buyer’s doing to get a deal done in these uncertain times?
This past week our team attended NMHC’s Annual Conference in Las Vegas with over 5,000 registrants and rumblings of nearly 10,000 apartment professionals attending.
Consensus is a challenging standard – especially across a massive cross section of people – yet it seems that the consensus among buyers is that patience will be rewarded.
And that is just what buyers are doing … waiting.
How is this manifesting into an investment thesis?
This is what we heard:
- “waiting until June to see what happens”
- “looking for opportunities to recapitalize construction projects”
- “pursuing properties with bridge loans using rescue capital”
- “needing discounts in excess of 20% from peak pricing”
- “watching for rent growth in Spring before betting on future growth”
Investors are requiring either months to pass or some economic trigger to make a move – both of which are not expected in the near term.
So here we stand as of February 2023, eerily mirroring pubescent teens at the junior high school dance: sellers on one side of the room with sub-4.5% cap opportunities in hand – and patient buyers at the opposite side of the room, pockets brimming with cash, tied to their principles of positive leverage and conviction of unknowable economic times ahead, needing time or certainty to cross the transactional chasm!
What is Going to Happen?
Despite a lack of conviction amongst buyers, we are hearing a lot of optimism. And it makes sense, with optimism action is rarely expected – yet conviction connotes a trend toward action, and of that there is little.
This must mean the future is quite uncertain, right?
I call bs.
During the last economic cycle in the Puget Sound region, personal income surged over 30% and concomitantly, cumulative rental rate growth topped 40%.
Per Capita Personal Income in Seattle-Tacoma-Bellevue
2012 to 2018
Source: US Bureau of Economic Analysis
During this period employment growth tracked 2.9% year-over-year. Yet, currently local economists are modeling a very impressive 2.7% annual job growth from 2023 to 2027.
If we achieve anywhere near this growth, rental rates will naturally follow the 6%+ year-over-year growth rates achieved from 2013 to 2017.
This next cycle of apartment value growth will not only be fueled by personal income and rental rate growth, but cap rate compression will also amplify the value equation.
Why am I so certain?
Interest rates will absolutely fall as there is no possible way the United States can withstand its current debt burden.
Net Interest Costs (Billions of Dollars) on the Federal Balance Sheet
2012 to 2032
The Federal balance sheet ballooned since the Great Financial Crisis, yet low interest rates kept the US debt burden manageable. This is no longer the case!
By 2027 – just 4 years from now and within the average hold period of most apartment investors – interest payments on Federal debt obligations will double, nearly guaranteeing a different rate environment in the next few years.
Net Interest Payment Obligation as a % of Federal Revenue
2012 to 2032
Net interest costs for our national debt will account for almost 40% of all Federal revenue by 2052. This is clearly unsustainable, even in the near term – especially from a political (electability) perspective.
Once interest rates drop, cap rates will assuredly follow, especially in primary markets like the Puget Sound.
The combination of increased building NOI and cap rate compression will predictably result in 20% to 40% asset appreciation over the course of the decade.
What To Do While Others are Sidelined?
We are in a unique time that sellers may consider 4.5% cap sales on core assets “reasonable”. A mere reversion to historic cap rates will demonstrate greater than 20% value increases. Couple that will NOI increases over the next 5-7 years, and you have a rock-solid thesis to enter today’s investment market.
The shift in investor sentiment will happen fast, it will only take a few sales. And when investors rush back into the market, the bidding will commence, once again pushing pricing to historic levels.
It wasn’t long ago when apartment buyers lamented few buying opportunities, waiting for some abatement in pricing.
Well, here we are.
Act now … every day that ticks by gets us closer to more certainty of the region’s economic vibrancy and you losing your pricing advantage.
About Dylan Simon:
I specialize in the sale of apartment buildings and apartment development across Washington State. With my co-founder, Jerrid Anderson, we operate a team of 11 apartment sales professionals dedicated to helping apartment owners and investors sell and buy apartment buildings and development land from $1 million to over $100 million.
CLICK HERE to contact a member of our team and to learn how we can help you Turn Our Expertise into Your Profit ©