By Jim Costello on April 7th, 2020
Making sense of apartment values is a challenging proposition in the midst of this coronavirus crisis. The pricing of publicly traded apartment companies and that for individual assets in private transactions was wildly disconnected in March. Preliminary data on asset sales in March suggest no real change in cap rates from February, while the price component of the FTSE Nareit Equity Apartments index was down 22% from a year earlier.
I am not going to wade into the debate over public vs. private pricing and which one is “right”. (I will choose another hill to die on.) There are technical and timing differences which drive the variation in price measures for each. Still, it raises an interesting question. Suppose apartment valuation changed enough to drive a 22% decline in the sale price of assets. What would it take to get there and how likely are these outcomes relative to what was seen in the last recession?
The question of what it would take can be answered by simple math. All one need do is take today’s cap rate and look at different combinations of changes in property income and cap rate expansions and calculate the resulting change in prices. The following table provides such a view but leaves unanswered a critical question: how probable are the outcomes of each row and column?
Each row represents the total change in property income from the peak of the economic expansion to the eventual trough. In the last recession, data from NCREIF shows that apartment net operating income (NOI) fell only a total of 4%. If we could expect such a minor shock this time, sure, apartment prices would not fall much if cap rates did not expand rapidly. This recession, however, will be very different from the last one for apartment demand, and therefore likely different for rent and occupancy.
In the last recession, there was a growth in apartment demand from renters by necessity. Homeowners who realistically never should have bought homes flocked to apartments and the homeownership rate declined. There is no such back door demand for apartment units coming in this recession. In fact, with the severe shocks to the real side of the economy with job losses, some of the recessions in the distant past may be a better example.
Following the Internet bust, apartment NOI fell a cumulative 15% from peak to trough according to data from NCREIF. In the 1980s, NOI fell a cumulative 42%. Where it will go this time though is uncertain. The economic data changes daily with millions being thrown out of work. However it shakes out, with millions likely unable to pay their rent, apartment income is not likely to be as favorable as in the last recession.
On the cap rate side, the apartment sector did outperform other property types in the last economic downturn. The RCA Hedonic Series for cap rates shows that from the lows in the economic expansion to the worst part of the Global Financial Crisis (GFC), apartment cap rates increased only 130 bps versus the 150-185 bps expansions seen for other major property sectors. At the peak, cap rates averaged 7.1% for the apartment sector.
One benefit the apartment sector had last time though was the stability of financing from the agency lenders. With a steady flow of capital from Fannie Mae and Freddie Mac, some of the worst losses seen in other property sectors where there was a lack of debt capital were avoided for the apartment sector. This time, apartments may not be so lucky because of chaos underway in the servicing of debt.
The debt challenges mean that apartment cap rates may not be as sheltered from mayhem as they were in the last recession. Interest rates are low in the current environment, with the 10yr UST well below 1%, but a low interest rate does not necessarily mean low cap rates. Spreads between apartment cap rates and the 10yr UST are at record highs but investor perceptions of risk are high as well. We can see that sense of risk in the large spread between corporate bonds and the 10yr UST which is at levels not seen since the GFC.
Every economic downturn is different and this one is no exception. Early in this economic downturn – meaning a couple of weeks ago – I was fairly optimistic that apartment prices could hold up ok, with only shocks to income as tenants delayed their rent. Now I am not so sure. Challenges in the real side of the economy are spilling over to the financial side and posing threats for apartment valuations not seen during the GFC.
Real Capital Analytics will release the Q1 2020 edition of US Capital Trends on April 22. If you are not yet an RCA client and would like to learn about RCA’s data, tools and reports, please contact us.
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