Why Apartment Cap Rates Are Projected to Remain Low

Spreads between bond and property yields are generous enough to absorb higher long rates in the short term, Investcorp wrote.

By Paul Bergeron | November 05, 2021 at 07:12 AM

The multifamily sector entered the pandemic on solid footing, and despite challenges brought on by the pandemic, it has the potential to continue to outperform in the years ahead, according to Investcorp.

Despite treasury yield increases, apartment cap rates are projected to stay low in the next couple of years, supporting an increase in capital values.

“The economic recovery continues in earnest, but this is raising questions about quite how transitory the current high rates of inflation are,” wrote Michael O’Brien Co-Head of Real Estate North America, Head of Residential Vertical, at Investcorp.

“Core inflation will likely stay elevated, which should force the Fed to push up rates. And while rising Treasury yields are projected to squeeze the yield gap enjoyed by apartments, given the strong prospects for NOI growth in the apartment sector, apartment yields are projected to stay low.”

Spreads between bond and property yields are also currently generous enough to absorb higher long rates in the short term, O’Brien said.

The current spread between apartment cap rates and 10-year Treasury yields is 186 basis points, above the 2001 to 2021 average of 200 basis points.

“Lower vacancy rates and accelerating rental growth will support apartment income. A substantial recovery in net operating income will mean that yields see little change over the year, despite strong investor demand.

“The industry is underpinned by strong fundamentals and it has shown resilience during these disruptive times. As such, despite the uncertain long-term implications of the pandemic, it should not affect the dynamics of supply and demand. Demand for multifamily property is expected to remain strong and will continue to outpace supply.”

O’Brien noted that younger generations saddled with student debt will find home ownership unattainable. And while the recent crisis has led to even more millennials and Generation Z living at home with their parents, they will eventually move out and become a strong pool of new renters. 

“Furthermore, the expansion of remote working means that people have more flexibility over where they live, which will likely favor cities where the cost of living is relatively more affordable.”

On the supply side, while the pace of new construction has picked up meaningfully compared to the lows seen a decade ago, this is projected to not be enough to make up for current housing shortfalls, O’Brien wrote. It is estimated that 2.3 million homes are needed each year over the next 10 years to balance the supply/demand imbalance. 

“Until construction ramps up, housing shortages will persist, increasing demand for the rental market. The multifamily sector is projected to continue to perform well as it has over the past two decades.”

He said that rental growth for apartments is also projected to continue to outpace inflation, making it a good hedge against the pressure of rising prices.

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