As we work our way through the first quarter of 2022 the big question everyone in the industry seems to be asking is “will interest rates affect cap rates, and will multifamily asset values decline?” This is an important question and one that takes careful consideration to answer.
As with most questions related to investment the answer starts with “it depends”. It depends on the specific asset and the market in which the asset is located.
Before we can really answer this question, it is important to clarify what a cap rate really is. As a mathematical calculation, a cap rate is a percentage ratio of a particular asset’s free cashflow to its value or purchase price. However, since an asset’s value is not a fixed number and can vary over time, cap rate is not actually a measure of free cashflow, but rather a measure of investor demand for a particular asset class, asset type, market or location within a market.
Cap rates are used to measure investor demand and measure an asset’s value; however, cap rates do not determine an asset’s value. Just like a ruler can tell you how tall you are, but does not on its own make you 6ft tall.
This can be confusing, because cap rates are often quoted by brokers when selling an asset and quoted by sponsors when referring to reversion cap rates and potential prices that could be achieved upon sale. The important thing to remember is that the cap rate is the shorthand measure of value, not the determinant of value.
What drives cap rates?
The actual value of an asset is determined by market factors, and business fundamentals of consumer supply and demand. Is the asset located in an area with an increasing population of renters? Is the asset located in an area with high barriers to entry for competing product? If so, then the law of supply and demand states that rents and property cashflow will increase. The relative value of the rental units will go up because demand for these units is greater than the supply of existing units and population growth will continue to push demand pressure beyond the future supply level due to the barriers to entry.
The basic economics of supply and demand is the base line principal for value. There are more nuanced factors in what makes up the value of an asset, such as the asset type, the number of similar competing assets, replacement cost, as well as local laws and regulations that may impact landlords. In the end, as long as there is strong and sustainable consumer demand for the product type, the asset will continue to produce consistent cashflow, and if an asset can produce consistent and reliable cashflow there will always be investor demand for that asset, giving it not only value today, but also in the future.
So, what impact will rising interest rates have?
Rising interest rates will no doubt have an impact on cashflow at acquisition. However future cashflow is determined by many other factors as well, such as location, the specific asset, and the execution of the business plan.
Demand for the asset will also be driven by the amount of capital seeking returns and the potential alternative returns (or otherwise) that may be available in the capital markets for investors. We are all aware of the amount of money that has been injected into the financial system over the last few years and this supply of capital will maintain a certain amount of downward pressure on the prices of attractive assets – particularly those that can produce reliable future cash flows, even in the face of increasing interest rates.
I expect there to be a shakeup throughout 2022 that will differentiate those assets with stronger potential to generate future cashflow, from weaker assets that lack the fundamentals necessary to see continued growth into the future.
As with any investment, it is important to understand the difference between inherent value and perceived, or assumed, value. It is important to remember the fundamentals that determine the value of a market or a specific property – cashflow, appreciation, and tax benefits. Those who can exercise discipline and stick to the principals of real estate investing will always see great success even in a shifting market environment.