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Dupre + Scott Apartment Advisors, Inc. Apartment market investment research & advice Timely, informed, unbiased analysis & insights 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 © 2017 Dupre + Scott Apartment Advisors, Inc. ph (206) 935-2915 www.duprescott.com [email protected] Page 1 of 6 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. © 2017 Dupre + Scott Apartment Advisors, Inc. ph (206) 935-2915 www.duprescott.com [email protected] Page 2 of 6 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 © 2017 Dupre + Scott Apartment Advisors, Inc. ph (206) 935-2915 www.duprescott.com [email protected] Page 3 of 6 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. © 2017 Dupre + Scott Apartment Advisors, Inc. ph (206) 935-2915 www.duprescott.com [email protected] Page 4 of 6 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. Support We hope you enjoyed this video and article. If you did, here is a shameless plug. Why not subscribe to our Apartment Advisor newsletter. It is ridiculously cheap, because it is filled with so much valuable information. Since our research is our only source of business income, we need your support to keep it going. [Click here] for more information about the newsletter. Better yet, save yourself a step and just order it online now by [clicking here]. Feedback Please give us feedback on this article and share any other information you think will be interesting and useful to people involved in the Puget Sound region's apartment market. We would be happy to quote you, adding your comments to this or other articles. We will also respect your privacy if you want your comments to be confidential. just let us know. [ Click here] for our contact form. More videos and articles Be sure to check back next week for a new video and discussion of current apartment trends for the Puget Sound region. Here are some other recent articles you may find interesting: Apartment development pipeline Apartment investment update Capital expenses and replacement reserves Rent an apartment or buy a home Apartment renovation trends © 2017 Dupre + Scott Apartment Advisors, Inc. ph (206) 935-2915 www.duprescott.com [email protected] Page 5 of 6 Dupre + Scott Apartment Advisors, Inc. Apartment market investment research & advice Timely, informed, unbiased analysis & insights Apartment financing trends Real estate taxes, assessments, and appeals © 2017 Dupre + Scott Apartment Advisors, Inc. ph (206) 935-2915 www.duprescott.com [email protected] Page 6 of 6