May072013

The federal reserve is inflating a bubble in the apartment market

Financial bubbles are inflated by investors who pile into an asset class with flawed assumptions. In most cases, these investors have unrealistic expectations for future appreciation and wouldn’t want to own the asset based on its cashflow alone. Such is the case with stocks, bonds, land, houses, tulips, and even gold. At some point, investors question their original assumptions on appreciation and start to sell. Of course, this causes any appreciation to stop, and even more speculators decide to exit. Further selling causes prices to fall which prompts even more selling that culminates in complete market capitulation and a crash in market pricing. As surely as the sun rises and sets each day, once an asset class becomes coveted for appreciation alone, a crash is inevitable.

The federal reserve distorts asset values

The federal reserve has lowered the cost of borrowing to near zero. As a result, there is plenty of cheap debt available to financial managers to invest. These managers are under increasing pressure to obtain returns, so they bid up the price of all financial assets in pursuit of higher yields. This inflates all asset classes, which is apparently what the federal reserve wants.

The cash returns on all cashflowing assets has been steadily declining due to all this cheap debt searching for a home, and financial managers have been forced to accept ever-more optimistic assumptions in order to justify their acquisitions. One of these assumptions is the future sales price. In other words, financial managers are starting to expect higher and higher rates of appreciation in order to make their deals work, and as I pointed out above, it’s the assumptions on future appreciation that lead to asset bubbles.

Cashflowing assets are more stable?

Investors in cashflowing assets prefer those asset classes because they are less prone to wild fluctuations in value — at least in ordinary times. However, we are not living in ordinary times. I first studied real estate finance in the early 90s. Cashflow assets like apartments or office builders were valued based on their current cashflow. At the time, the general rule of thumb was that you borrowed 80% of the money at 8%, and the 20% equity was supposed to obtain a 12% return to compensate for risk. Investors would create what’s known as a stablized first-year proforma with these parameters to establish a market value for a cashflow property. Future appreciation was generally not considered because at a 12% discount rate, the profit ten years out had so little additional value that it could be ignored.

After 30 years of falling interest rates and cap rates less than half of what they were when I was in school, investors are accustomed to what’s known in the industry as cap rate compression. What investors found over time is that while they were buying based on an 12% yield, their future buyer would proforma an 8% yield, so properties were appreciating much more than their original proformas anticipated. The appreciation greatly contributed to their returns. And since this has gone on for such a long time, the expectation of future appreciation became part of everyone’s proforma, and before they realized it, cashflow investors became speculators — all because the distorting effect of federal reserve interest rate policy.

Apartment investment today

In today’s apartment investment market, investors are buying at cap rates in the 4% to 5% range. Their proformas have overly aggressive assumptions of rent growth and occupancy, and most importantly, they assume they will sell out years from now to an investor who will accept a 3% cap rate. Based on their experience of the last 30 years, their assumptions of cap rate compression are reasonable. But are they really? It is reasonable to assume investors ten years from now will accept even lower cap rates? This is the bubble forming.

So why are investors funding these deals? These guys are not stupid, they see conditions I just described, but they fund the deals anyway. Why do they do it? Because the federal reserve has pumped so much cheap debt into the economy that they don’t have any better alternatives. It’s the same reasoning that has financial managers buying longer duration bonds, which are also in a bubble.

Manager Compensation

The people who put together these deals make money two ways. First, they take 1% off the top, which in an environment of 4% yields makes many deals hard to pencil out. When cap rates are 10% taking 1% is only 10% of the cashflow, but at 4% their fees are 25% of the cashflow. Despite this obstacle, many deals still get funded. The remainder of the manager’s compensation comes from profit (or IRR) at the back end. If these managers do not perform as they projected — if they can’t get the cap rate compression they counted on — they won’t make much if anything at the back end. I think it’s likely that many of these managers who are riding high today will be greatly dissappointed when the apartment bubble bursts and the huge payout they are expecting on the back end fails to materialize.

Who Is Buying All These Apartment Buildings Anyway?

Mark Hickey, Quantitative Analyst — CoStar Staff — April 24, 2013

It’s no secret that the apartment capital market has been white-hot lately. …

This trend is no doubt the result of a giant increase in capital offerings for REITs.

The chart below shows the capital offering for REITs on the right axis and trading volume on the left axis. From 2008-2009, public REITs were large net sellers, as their share prices dropped and they sold off assets to maintain their LTVs, accounting for 20%-25% of all apartment sales by dollar volume.


However, as REITs regained favor with investors, it became easier and cheaper for them to raise capital, and the amount of cash they had to put to work grew tremendously.

This is impact of the federal reserve’s zero interest rate policy.

In fact, capital raised in 2012 was a staggering 20 times larger than it was in 2008….

This means that it’s gotten pretty hard to outbid a REIT that has set its sights on buying an apartment property. Dividend yields are only in the threes, so it’s okay for a REIT to pay a cap rate that’s in the fours. …

If you had told my professors 20 years ago investors would be doing this, they would have thought you were crazy.

How long other investors will be competing with REITs depends on where public apartment REIT pricing is headed. Over the past three years the stock prices for REITs have had a compound annual growth rate of 28%, compared to 13% for the S&P 500. Is this perhaps a sector bubble, or just a bounce back from the recession?

I think we know the answer to that question.