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How to Take Advantage of Recent Core Multifamily Growth

Submitted by M. Drouin
Core real estate asset total returns have been on a tear since 2010.  Total US property returns have achieved 13.1% to 14.3% in 2010 and 2011, respectively.  It appears that institutional investors have an appetite for more acquisitions, especially core multifamily apartment properties.  In light of this, asset owners and managers that manage core assets should position them for some opportunistic pruning and twist their equity into the clearly undervalued non-core assets.

Topics in this post:

  1. The state of the core apartment real estate market, some of its key players and why we can look forward to further compression of cap rates relative to cap rates on non-core assets.
  2. RE debt markets and how those recovering markets could further exacerbate asset appreciation of core.
  3. Recommendations of how to take advantage of the impending market inefficiencies that could result from overvalued core multifamily assets.

In the world of statistics, the law of large numbers dictates that data will tend to trend towards the average over the long term.  In the paper published by the NCREIF conveniently titled “Is Core Overvalued?”, the cap rate spread between core and non-core properties is at its highest in over 12 years.  At the height of the real estate boom, the cap rate spread reached 0.60%.  For 2012, it has reached 0.60%; that’s a 100 basis swing in just over 4 years.  This may be attributed to perceived risk on deemed risky non-core assets.  Also financing has been much easier to come by in Core since the economic crisis either through debt or equity deals.  What will further this anomaly is the fact that intuitional titans like TIAA-CREF and CalPERS are penciling in billions of dollars of investments into core real estate assets.

CalPERS is “…buying core even though core prices in some cities are high….  When officials began reorganizing, the portfolio was overweighed in opportunistic and value-added  real estate and underweighted in core.”  When pressed about the valuation metrics of core versus non-core properties, senior investment officer of real assets, Theodore Eliopoulos “acknowledged that price of core as a concern.”  But replied, “’One way to mitigate the risk of purchasing core at what are pricey numbers is to have allocations in the hands of a handful of strategic partners that have successfully navigated several market cycles.’”4

PREA recently released their Q2 2012 consensus forecast survey. Respondents are surveyed on their forecast of the NCREIF Property Index (NPI.)  The consensus forecasted that the apartment asset type will outpace the NPI Total Return from 2012 to 2016.  Survey participants expect apartment total return to beat NPI by twenty basis points per year over the 2012 to 2016 time period.  Incidentally, they also expected apartment appreciation to outperform all others by 60 basis points.  In comparison to previous survey forecasts, the most recent have evolved to become markedly rosy for apartment asset returns from 2010 Q4 forecast of returns in the mid 9% to 11% returns in the most recent 2012 Q2 forecast.  Cap rates have also been compressing on core apartment assets over $5 million, from 6.94 in 2009 to 6.25 in Q1 of 2012.

Access to debt is incredibly important to asset valuation.  For example, if collateralized debt is extremely easy to obtain, it tends to turbo-charge the underlying asset prices.  In the Commercial real estate debt market we have endured over three years of capital outflows.  According to the real estate firm AEW, we are looking forward to one more year of negative capital outflow from commercial real estate debt markets as deleveraging continues.

To put the debt hangover into perspective, CMBS issuance in the US reached over $228 billion in 2007.  Since then CMBS issuance hasn’t broken above $33 billion in any given year since the financial crisis.  Long term average commercial real estate debt to GDP ratio is 15%.  We are still riding at over 20% of GDP.  This further supports the notion that we are still experiencing a debt hangover and that deleveraging will continue.  That or GDP will have to grow in a significant capacity to offset this.  Most economists will concur that we have a lack of catalyst to supporting the latter.  So in short, we will continue to see less capital flow into the marketplace.  This will pose a significant opportunity to institutions that have access to capital or simply do not need it due to a strong liquidity position.

Once commercial real estate debt issuance normalizes, there will be a further compression of cap rates on core assets.  If you manage a portfolio of commercial real estate assets strewn across the various property types, it may be prudent to consider positioning your core apartment portfolio for a strategic pruning and consider allocating more of your equity into wider cap rate noncore apartment assets.  Get a pair of impartial eyes on your apartment portfolio to evaluate process improvements that may not be utilized; causing you to leave money on the table.  Multifamily management is no longer a cottage industry!  Fixed costs are high and variable costs are low, so every dollar generated or saved has a multiplier effect to your assets’ value when integrated into capitalization rate models.  Contact us for a portfolio evaluation to receive objective advice on maximization of your total return strategy.  Our client scope is 300+ unit apartment portfolios in the Eastern and Central United States.

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