Inflection Point: Rising Cap Rates and Receding Investment Opportunity in the Urban Core
Multifamily is an attractive asset class with a track record of favorable risk-adjusted returns, a high dividend payout ratio and healthy growth of net operating income. Over the last cycle, the segment has benefitted from structural tailwinds which afford some insulation from disruptive forces. These tailwinds include favorable demographic trends, lifestyle preferences that favor renting, flat homeownership and tighter mortgage standards. However, the composition of those benefits varies based on location, and the urban core has long been the focus for greater opportunity. That view, however, is changing, which can be quantified using apartment transaction data from Real Capital Analytics®. Price appreciation for assets in the urban core is slowing, and cap rates are rising.
With respect to methodology, we breakdown transaction metrics for the top 100 metros in the U.S. (though exclude New York and Northern New Jersey). Further, we identify transactions with verified transaction prices and cap rates.
Transaction volume began to grow in 2010, remaining healthy but moderating this year. Firms are finding the volume of assets available for purchase that make sense from an investment perspective are more scarce, both from an availability and pricing standpoint. The slowdown is apparent across all distances from the center of the metro areas we covered. By region, the slowdown is more pronounced in the West, the most expensive region relative to others.
On a per unit basis, the change in prices for units in the inner-most urban areas have plateaued – skewed in part by expensive coastal markets, there’s been a significant premium in this segment. Another consideration is supply. The volume of new construction in the urban core has swelled to record levels in several markets. Meanwhile, prices generally continue to climb among other distance segments. We are still seeing healthy price per unit growth in suburban areas.
Over the last cycle, cap rates have compressed across the board, from 6.83% in 2010 to 5.32% as of 3rd quarter 2017. Specifically, they have compressed more in the urban core. In making an investment decision for a long-term hold, there is generally more confidence to deploy capital in the urban core as these are perceived as the stable economic anchors in the local economy. That thinking has modified throughout the latest cycle, extending to some suburbs with healthy employment growth and favorable demographics. However, performance across suburbs is varied, with high-performers and laggards among them.
By region, the West reported the lowest cap rates in the urban core (and in suburbs). Many of the large coastal urban metros contribute to lower cap rates. Meanwhile, the Midwest region reported greater cap rates in the urban core. Generally, these are slower-growth metros with varied economic performance, translating into greater relative cap rates. Cap rates in the South and Northeast trace each other closely.