Download Cap rates and mortgage rates

Dupre + Scott Apartment Advisors, Inc.
Apartment market investment research & advice
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Cap rates and mortgage rates
This is our weekly discussion of apartment market trends, for Friday, December 28th, 2012. This
week we take a look at the relationship between capitalization rates and mortgage rates.
Capitalization rates move higher or lower for a number of reasons. Supply and demand is one of
them. More buyers chasing fewer deals will tend to bid up sale prices, lowering capitalization rates.
That was clearly evident between 2005 and 2007.
Another reason capitalization rates move higher or lower is as a response to changes in the cost of
capital. Since most apartment sales involve substantial financing, changes in mortgage rates have a
significant impact on capitalization rates. The graph below shows the trend since 1979.
The capitalization rate is the average actual capitalization rate each quarter. We show two different
rates. the "actual" cap rate is based on revenue at the time of purchase. The "anticipated" rate is
based on revenue expected 3 to 6 months after purchase. The anticipated revenue is almost always
higher because of expected rent potential from renovation or a new management style.
The mortgage rate is the average interest rate buyers secured on their financing. It averages variable,
fixed, and seller financing rates. We don’t have data prior to 1979, but our recollection is that since
getting into this industry in 1975, investors have been faced with “negative” financial leverage. That
continued until the early 1990’s.
Negative financial leverage
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Dupre + Scott Apartment Advisors, Inc.
Apartment market investment research & advice
Timely, informed, unbiased analysis & insights
Negative financial leverage means your mortgage rate is higher than your capitalization rate, which
negatively impacts cash flow. If you buy an investment that makes 5%, it doesn’t make much sense
to borrow money at 10% to buy it.
This graph shows that negative financial leverage was the norm all through the 1980s. Investors
didn't get to benefit from positive financial leverage until the early 1990s. But when investor activity
heated up in the late 1990s and between 2005 and 2008, buyers bid up prices, lowering cap rates and
creating negative financial leverage.
At the beginning of our career we read real estate text books that talked about positive financial
leverage, or buying at capitalization rates higher than mortgage rates. But we didn’t experience
positive financial leverage for the first 17 years in the business.
It really was different
So why were apartment investors willing to accept negative financial leverage then? We often hear
people claim, “It’s different this time,” but it usually isn’t. They just want it to be different. They
don’t want the normal rules to apply, because they don’t like the outcome they’d produce. Well, it
really was different then. Here’s why.
Inflation
There are more reasons to buy apartments than just cash flow. First, the inflation rate averaged over
10% a year between 1980 and 1982. It averaged over 5% a year between 1988 and 1992. Inflation
usually brings with it higher rents and sale prices. Rightly or wrongly, during inflationary periods
investors anticipate higher than normal appreciation.
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Dupre + Scott Apartment Advisors, Inc.
Apartment market investment research & advice
Timely, informed, unbiased analysis & insights
Tax shelter
Second, investors enjoyed tremendous tax benefits until 1986. The normal “sales pitch” to a
prospective investor back then was, “you get your down payment back in three years from tax
shelter alone.”
The tax benefits had a significant economic value, which helped offset the disconnect between
capitalization rates and mortgage rates. Plus, the lure of tax savings brought a lot of new investors
into the market who might not have understood the product or the market very well. If that was the
first time this happened, it wouldn’t be the last.
You can see that when those extreme tax breaks disappeared in 1986, investors tried to bring
capitalization rates in line with interest rates. They managed to do that until the next inflationary
cycle took hold of the market mentality again in 1988.
Finding balance
Both mortgage rates and capitalization rates trended lower slowly during most of the 1990s. In
1991, when investors were buying apartments at 9% capitalization rates, they were generally getting
financing at 9%.
So, if your investment makes 9% and you borrow money at 9% to buy it, you also make 9% on your
down payment in cash flow. That’s simplistic, since it excludes the “cost” of making a monthly
principal payment, but it’s a useful way to look at the relationship. It also ignores the risks and
rewards of leverage at the time of sale. By 2000, investors were buying at 7.5% capitalization rates
and getting financing at about the same rate. So they were making about 7.5% on their down
payment.
Positive financial leverage
The relationship started to change early in this decade. As interest rates fell between 2001 and 2004,
capitalization rates headed lower as well. But they didn’t fall as fast. That was probably due, at least
in part, by the impact of the recession. Vacancies were above normal, rents were lower, and
investors were cautious. As recently as 2004, investors were buying deals with 6% capitalization
rates and getting loans at 5%. That’s called positive financial leverage and it’s hard not to make
money when you can get it. But as the graph shows, investors don’t get it often.
Buyers get bullish
Then, even though interest rates rose in 2005, capitalization rates kept falling. That was due to
increased buying pressure. Investors were willing to outbid each other to the point where they
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Dupre + Scott Apartment Advisors, Inc.
Apartment market investment research & advice
Timely, informed, unbiased analysis & insights
increased buying pressure. Investors were willing to outbid each other to the point where they
bought deals that generated a yield near 4.5%, while their debt cost them 6.5%. You can’t make
money that way unless you are betting on significant increases in net operating income. They were,
and it worked. At least it worked for a while. Of course, you also have to be betting that the investor
you sell to someday will accept equally low capitalization rates.
What’s next?
Capitalization rates started moving higher in mid-2007 and didn’t stop climbing until the middle of
last year. But cap rates have fallen fairly steadily since then.
Cap rates are falling for two reasons. First, investors want to buy apartments again. More buyer
competition means they are lowering their yield requirements just to be able to buy something. The
second reason is that interest rates have generally trended lower. The rates we’re tracking combine
fixed, variable, and seller financing rates actually secured on sales. These rates have averaged less
than 4.5% all year.
When investors can buy at a 5% cap rate and get financing at 4.5% or even 4%, they have positive
financial leverage. That’s a good thing. Although it doesn’t guarantee long term financial success, it
does mean they at least start out with cash flow. That’s an important first step, one that was missing
between 2005 and 2008.
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Dupre + Scott Apartment Advisors, Inc.
Apartment market investment research & advice
Timely, informed, unbiased analysis & insights
Be sure to check back next week for a new discussion of current apartment trends for the Puget
Sound region.
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Puget Sound region. Here are some other recent articles you may find interesting:
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Dupre + Scott Apartment Advisors, Inc.
Apartment market investment research & advice
Timely, informed, unbiased analysis & insights
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