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Decomposing Apartment Returns and Strategic Implications

Decomposing Apartment Returns and Strategic Implications

For real estate investors, it doesn’t get any better than owning assets in an environment where cap rates are compressing. You know what I’m talking about. We all aspire to experience the euphoria that comes with a quick strike. These feelings soon become the main topic at cocktail parties as conversation shifts from breaking the ice to that of killer IRR returns. While pricing effects from cap rate movement can have a major impact on total returns, it is not the historical norm. In fact, historically speaking, 70% of positive returns have been driven by income while a mere 30% came from appreciation, according to NCREIF data. The tables turned only in the past decade.

Below is nearly 30 years of NCREIF apartment returns decomposed between income and appreciation. What is evident from the chart is that income returns are by far the most stable component of return. However, extreme oscillation between appreciation and depreciation of asset values is what investors remember today. With that being said, it is important to recognize at this point in the current cycle, real estate returns moving forward will be much more reliant on improving fundamentals rather than further cap rate compression.


New supply is expected to slow the current pace of rent growth, which would lead to slower NOI growth. This would suggest we can expect to see lower total returns in the short term. And so far, that is exactly what we have seen. Since total returns for the NCREIF apartment sector hit 18%in 2010, we have experienced three consecutive years of diminishing returns and are on pace for a fourth. Longer term, occupancy is expected to remain high once new supply is absorbed (thank you secular bull story) and returns should improve, since rent growth and occupancy are highly correlated. Until then, focus should be shifted to assets with healthy short-term outlooks in order to boost returns. Strategic implications would suggest shifting your focus to markets where employment trends and wage growth expectations support higher rents. In addition, investors would be wise to focus on newer vintage assets that require lower capital expenditures, another enhancement towards higher income returns.

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