Second-Half Surge? There’s Still Room for More Cap Rate Compression

By , Multifamily Executive.

Foreign capital, healthy risk premium continue to drive prices up and cap rates down. But for how much longer?

Though transaction velocity is slowing, the second-half of the year may see something of a rally in volume—pushing capitalization rates down further.

While cap rates hit another low in April—with mid- and high-rise property averaging 4.6% in April—some brokers see further room for compression as an influx of foreign capital continues to target U.S. real estate in a flight to safety.

So, will cap rates continue to fall?

“It’s certainly possible,” says Danny Kaufman, a Chicago-based managing director for commercial real estate broker HFF. “The spread between the yield on the 10-year Treasury and multifamily cap rates—the risk premium—is still wide by historical standards.”

And that spread has been made healthier in the last few weeks as the yield on the 10-year Treasury bond went from 1.85 on June 1 down to 1.51 on June 16th (it bounced back up a little since, at 1.65% June 20).

Even in some of the major gateway markets, like New York and San Francisco—which didn’t seem to have a lot of room left for compression—cap rates have ticked down a bit this year.

“You’ll see some trades at 3%, maybe a tick below,” says Mitchell Kiffe, a senior managing director with brokerage firm CBRE. “But I think some of the uncertainty in the world is causing U.S. real estate to continue to look attractive to foreign capital.”

Cross-border Compression

Indeed, that combination of a still-healthy risk premium, and foreign institutional money looking for a home, continues to drive prices up and cap rates down.

“You have foreign capital, which is a huge part of the market, coming in from China or the Middle East, and they want to put their money in a strong stable investment vehicle, which multifamily clearly is,” says Eric Fixler, a senior director at brokerage firm Marcus & Millichap. “That’s why I think you’re seeing cap rate compression, because there’s so much money floating out there. Investment funds have to deploy capital—they’re getting paid to put that money out there.”

While large investment funds continue to drive prices up and cap rates down, the question is, how much longer will that be the case?

“We’re at that sort of plateau at the bottom; in certain major markets there will still be some compression but at some point, yields are so low that people will say ‘I’m done,’” Fixler says. “I don’t think we’ll see a lot more compression because investors are hitting the bottom of the barrel in yield and there’s a point at which it doesn’t make sense to invest.”

Second–half Surge?

CBRE’s Kiffe sees an increasing amount of institutional money chasing yield into secondary markets or assets, as all of the low-hanging fruit has been plucked for years.

“The capital flows to core multifamily assets have been less strong, and there’s been more activity in the core-plus and value-add segments of the market,” says Kiffe. “We’ve seen concern about some of the supply in major markets and the impact it’s having on occupancies. I think there’s a concern with Class A properties in primary markets, that the rent growth will not be as strong as it has been.”

But while preliminary transaction data as reported by Real Capital Analytics showed another tough month for volume in May, Kiffe believes that June, and the latter half of 2016, will see a rally in transaction velocity.

“We saw a slowdown clearly in the first quarter,” says Kiffe. “But we see a lot of investment sale activity coming. So we think the end of the second quarter will be strong, as well as the second half of the year. All of our professionals have been very active in getting ready to bring properties to market.”

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