Making Sound Judgments When Pricing Real Estate

Thanks for joining us and welcome to The Multifamily Memo! ?A newsletter that provides insight into?current market conditions and tools that we use to navigate its intricacies.?

This newsletter comes from a unique perspective in the industry– four (4) decades of investing and operating over 50,000 multifamily units nationwide.

Real estate investing (and some argue human nature) has always been cyclical.? As with past cycles, many of today’s newer firms and investors have never experienced a downturn.? We have been in an extended period of easy money and consistently declining interest rates providing investors with tremendous tailwinds and lots of runway for mistakes.?

Simply put – from 2009 to 2022 it was hard to lose by investing in the multifamily sector!

This abruptly changed in early 2022, when the Fed realized that its Pandemic era stimulus package had induced inflation rates not seen since the late 1970s.? In response, the Fed quickly reversed course and embarked on the fastest rate hiking cycle in history.? The impact was almost immediate in the marketplace with transaction volumes falling over 70% in both 2022 and 2023.?? Why?? By and large, multifamily prices no longer made sense in the new interest rate environment.?

We will move further into our perspective on the runup to the pricing reset we are now experiencing in future issues, but for now let us kick off our inaugural edition with our thoughts on, the biggest issue in the industry…pricing.??

We often hear of “risk-adjusted return” in real estate.? Due to the lack of historical returns information, private real estate, with some narrow exceptions (NCREIT indices), does not easily lend itself to the traditional risk-adjusted measures (standard deviations, sharpe ratios, etc.).

Therefore, industry veterans gauge asset and market risk using historical “cap rate spreads” as an indicator of a particular investment’s attractiveness.? A cap rate is simply a property’s net income return, expressed as a percentage, when bought for all cash.? For example, if you buy a property for $1M and your net income is $80K you have an 8% cap rate.

A cap rate spread is simply the premium above a certain baseline yield meant to compensate for the additional risk inherit in real estate investment (market, operating, liquidity, etc.).? The most used baseline yield in real estate is the 10-year Treasury.??

Since the Great Recession of 2008, cap rates, on average, have yielded 300bps (3%) more than the 10-year yields. ?With the current 10-year yield (~ 4.25%) this would indicate cap rates need to be in the 7.25% range to reach its average spread.? ?Currently cap rates are roughly in the 5.75%-6% range.? This indicates real estate is still around 17% overvalued using this particular baseline.? This is well illustrated in the following chart:

It should be noted that the 10-year cap rate spread is constantly in flux and not a perfect indicator of value, but it does provide important historical guidance on where the market is in terms of overall value.

In our opinion, effective use of the cap rate/10-year spread is to use the medium 10-year yield over a 15-year period.? This mitigates short-term anomalies, such as the virtually zero rate period we experienced during the pandemic.

This would have prevented many sponsors from overpaying for deals during the pandemic if they had underwritten their exit cap rates using the 10-year 2.90% 15-year medium as a baseline - instead of assuming the 10-year yield would remain at pandemic period yields.

We will wrap up this issue by saying there are other historical baseline indicators experienced firms use such as the BAA bond and mortgage constant spreads to evaluate the market.? We will cover some of these and much more in future issues.

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