Low cap rates on institutional-quality properties have sparked a debate about the attractiveness of current apartment acquisition opportunities. But it appears that the investors paying these low cap rates were just well ahead of the curve. Yes, cap rates of 5% or less feel pricey, but only in a historical sense. On a relative basis, 5% cap rates still present an attractive investment alternative in an environment where yields have been compressed across most asset classes, given a 10-year Treasury rate that starts with a one or at best a two.
At the end of 2010, a 465-unit complex in the Seaport District of Boston sold for a 4.5% cap, and many people were left scratching their heads at such high pricing. But in the time since that purchase, rents in the Boston CBD have risen over 10%, effectively raising that going-in cap rate by nearly 50 basis points. Not too bad, and even better if we get the level of rent growth expected. More recently, in November 2011, a 228-unit suburban complex in Salem, Mass. joined the crowd and sold for a 5% cap rate. Again, people were left asking if that was too high, particularly for a suburban asset. The low level of residential construction over the past several years (for single-family homes as well as multifamily), combined with a fairly healthy local economy, unemployment below 7%, and rising median household incomes, has driven vacancies to very low levels (below 4% for the metro and under 3% for the CBD). And they should remain at these levels for the foreseeable future, with deliveries expected to remain minimal through at least the first half of 2013.
All the factors above point to really strong rent growth for the next couple of years. At PPR we are forecasting annual rent growth of nearly 7% in the CBD and almost 6% annually for the metro over the next five years. These rent growth projections rank Boston first in the nation for rent growth, and I would advise owners and managers to be pushing rents pretty hard. Given the strength of Boston’s economy, the ratio of rents to median household income is well below average compared to historical standards, indicating the capacity of tenants to absorb further rent hikes. Unlike the case for most commercial leases, apartment leases roll quickly. And if you push too hard, it’s fairly easy to correct and bring occupancies right back up to match the market average.
Spreads for the two transactions mentioned earlier were over 250 basis points when the deals closed. At the peak of the most recent market high, mid-2006, spreads for average assets got down below 200 basis points. We can easily argue that these two transactions were both for better-than-average assets, as both large complexes had great occupancy and were new — which means anything built in the last decade by New England standards. Consequently, cap rates for these superior assets should be lower than the market average, and in fact they were. Average cap rates for the Boston market, however, have been in the 7%–8% range (nearly 150 basis points higher than for San Francisco and San Jose properties) over the past 18 months. As these stats clearly show, were one to simply look at nominal cap rates, Boston’s multifamily real estate would appear pricey. But when viewed in the context of investment alternatives — the more appropriate view in our minds — Boston apartment acquisitions still make sense, particularly for those lucky enough to find value-add assets. The current market dynamics are a golden opportunity for multifamily owners, so go out and turn those rents into gold.
James Mealey is the Boston Senior Market Advisor for Property & Portfolio (PPR), a subsidiary of the Costar Group, Inc.