The concept of cap rates is an interesting phenomenon when you stop to think about it.
Short for “capitalization rate” and calculated as net operating income (NOI) divided by sales price, this all-important real estate metric represents a page borrowed from Wall Street’s playbook, a savvy maneuver by investors to create a vehicle of asset valuation and apply it to select securities on a widespread basis.
The circumstances of the metric’s inception are largely unknown, but all that matters is that the real estate industry has successfully propagated the use of cap rates as a crucial mechanism to underwriting and pricing transactions for these assets. And the most basic thing to know is that to a point, sellers like low cap rates because they reflect high purchase prices, and buyers prefer high cap rates for the opposite reason.
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Yet for all their ubiquity, cap rates are fluid, representing snapshots of valuations at random points in time. Tenants move out, leaving spaces vacant, and a property’s cap rate will likely be elevated when it comes time to sell due to the hit to its NOI. A similar property across the street fetches an above-market price, and the property’s cap rate compresses. The Federal Reserve hikes or cuts interest rates, and cap rates shift across the board one way or the other.
The “to a point” piece of the aforementioned analysis hinges on the fact that cap rates are also used to assess risk. For example, a cap rate in the double digits might indicate a low purchase price relative to comparable buildings, but a buyer might still be reluctant to pull the trigger on such an acquisition due to concerns over resale pricing. There would likely need to be something else to sweeten such a deal, such as the potential to implement capital improvements, raise rents and further boost NOI, thus bringing the cap rate down.
The latter factor has, of course, been the star actor on the real estate stage for the past 18 to 24 months, culminating in a presumably final act that kicked off with a 50-basis-point cut to the federal funds rate in mid-September. Less than one month later, a panel of multifamily investors gathered at the Westin Irving Las Colinas Hotel in Dallas-Fort Worth (DFW) to discuss the ramifications of the move. In doing so, they immediately invoked the concept of cap rates and identified the range at which they would be comfortable buying and/or selling properties in today’s market, all other factors being held equal.
“We’re seeing a lot of cap rates on value-add deals that are very competitive, around 4.5 or higher, but we’re buyers all day at 5-caps going in,” said Bill Rose, investment officer at metro Philadelphia-based EQT Exeter. “We think that in the next few years, the market for multifamily will be very strong and that cap rates will be compressing. On our revision assumptions, we typically keep our going-in cap rate close to where we’re going to exit.”
Rose’s use of certain terms like “going in” and “exit” speak to the aforementioned underwriting process, in which investors make financial projections for the buy, hold and sell phases of the deal. Rose was also asked whether the goalposts had moved over the course of 2024 in terms of cap rates at which his firm was willing to transact, illustrating the mercurial nature of the metric.
Exit cap rates are especially scrutinized in rising interest rate environments, as many buyers do not want to be in negative leverage, defined as a situation in which the buyer’s all-in interest rate exceeds the exit cap rate. Some investors will accept negative leverage in the short run, however, if they are optimistic about strong rental rate (i.e. — NOI) in the ensuing 12 to 24 months. In Texas multifamily markets like Austin and San Antonio, this scenario is a common topic of conversation, as experts believe these markets are oversupplied and subject to soft rent growth in the short term but poised for long-term success due to exceptional job and population growth.
Giuseppe Thum, director of acquisitions at Houston-based investment firm Venterra Realty, was the next panelist to weigh in on cap-rate sweet spots. In doing so, he gave a nod to the role that negative leverage plays in determining the range.
“It depends on the deal and what we can see for reasonable growth expectations over the first couple years, but a deal that works for us [today] tends to be in the low- to mid-5 [percent] range going in — probably closer to 5.25 [percent] on average,” he said.
“Our investment committee is very sensitive to supply and the resulting dampened rent growth that we’ve seen over the last year or so,” he continued. “We have to be confident that we’ll see solid rent growth in the first couple years for that low 5 [percent] cap rate to solve for the average yield we like to see.”
Panelist Ammanuel Metta, managing director of acquisitions at California-based TruAmerica Multifamily, who had previously asked Rose about the shifting range throughout the year, spoke next. Metta touched on movement of the 10-Year Treasury yield, which has been exceptionally volatile over the past six to 12 months and has not always moved in expected directions.
“If you look at five- and 10- [Year] Treasuries, we were 100 basis points higher a year ago,” he said. “At the start of the year, we were focused on newer value-add deals, looking to be at about 5.25 [percent cap rate]. TruAmerica has historically focused on workforce housing — 80s and 90s product with heavy value-add [components], but we didn’t think we were seeing appropriate yields on those deals.”
“Workforce housing deals were trading at 5.4 or 5.5 [percent cap rates], and you could get a 2015 construction deal at 5.25 [percent cap rates], so the risk-adjusted return metrics just didn’t work there,” he continued. “So now we’re focusing more on late-2000s product in the 5 to 5.25 [percent cap rate] range. For newer product, we’re looking to be at about 4.75 to 5 [percent cap rate range] and a little higher if there’s [value-add] lift on it.”
Metta also touched on the concept of replacement cost, or the relative difference between buying and building a property. He noted that due to a myriad of factors that have sent costs of new construction to the moon, many deals in today’s market can be bought below replacement cost. He referenced a specific deal in Denver that was underwritten at a fifth-year exit cap rate that is equivalent to what it would cost to build today.
Grant Raymond, senior director of the Sunbelt Multifamily Advisory Group at Cushman & Wakefield’s Dallas office, offered a broker’s perspective. He said that generally speaking, his team is seeing deals trade at cap rates between 4.75 and 5.25 percent.
“The 4.75 [percent] deals has been more for core product, while core-plus value-add has typically traded at a 5 to 5.25 percent,” he said. “We’re still seeing capital being very aggressive now, and most groups are still comfortable with 12 to 18 months of negative leverage, though they need to see that path to net-neutral within the first year.”
Raymond added that buyers in today’s market are generally bearish in their underwriting of rent growth — even factoring in concessions in some cases — and are especially sensitive to elevated operating expenses like taxes and insurance.
“It’s been challenging to see where or how you can move NOI in the first year, but we are still seeing plenty of capital in-migration to DFW and Texas markets, but 4.75 to 5.25 [percent cap rate range] is what we’re seeing on most underwriting today.”
— Taylor Williams