No Two Cap Rates Are The Same
We often talk about the benefits of investing in low cap rate markets with high barriers to entry and excellent demand growth —markets like Los Angeles. It’s worth expanding upon that concept.
Today, we discuss the importance of (1) comparing the fundamentals that underpin cap rates between different markets and property types; and (2) how both cyclical trends in investor psychology and capital flows can distort the relationship between those fundamentals and cap rates.
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The ability to identify these cyclical distortions and understand the resulting risks and benefits of buying potentially mispriced assets is what helps to distinguish between different investment managers and strategies.
Investors who simply believe that investing in markets or product types with high cap rates are inherently more attractive than markets or product types with low cap rates ignore the importance of supply-demand fundamentals and other risk factors that underpin cap rates and asset pricing.
In short, no two cap rates are alike.
Cap Rate Basics
Investors often use cap rates to make quick, back-of-the-envelope valuation comparisons among potential investments. The cap rate, or capitalization rate, is calculated by dividing a property’s Net Operating Income (NOI) by its market value (or purchase price). It’s essentially the inverse of a PE ratio for stocks.
Cap Rate = Net Operating Income / Market Value
Cap rates are expressed as a percentage, and will vary depending on the individual property, property type (e.g. retail, office, apartment, etc), market location, current income and expected future growth. The lower the cap rate, the more valuable a property is deemed to be for a given stream of income, including its expected annual cash flow and residual value upon sale over a particular holding period.
Three Fundamentals Influencing Cap Rates
There are many factors that influence cap rates related to apartment investments. These factors typically fall into three general categories:
- Macro-Economic Factors – Current and likely future macro-economic factors such as the state of the economy, interest rates, availability of capital and expected returns relative to other alternative investments with similar risk profile;
- Growth Expectations –The likelihood of future rent growth due to the health of the overall economy, employment and population trends driving demand, and barriers to entry limiting supply; and
- Risk – Real estate market risks related to the investment itself, including location, quality of improvements, character of income stream (annual returns vs residual returns on sale).
A common thread that binds these three categories together – macro-economic factors, growth expectations, and risk – is investor psychology.
The Importance of Investor Psychology
At any given point in time, investor perceptions about a market’s growth potential and the resultant risks can greatly impact capital flows. Investor sentiment can effectively push cap rates (i.e., valuations) up or down depending on desirability of a particular property type or market at different times during a market cycle.
For example, many secondary markets like Phoenix, Nashville, Austin and Dallas saw tremendous net gains in both jobs and populations during the pandemic. People moved out of the gateway cities toward some of these more affordable markets for lifestyle or other reasons. In turn, demand for residential real estate in these markets soared. The capital markets responded with significant inflows of debt and equity. This drove housing prices up and cap rates on apartment buildings down to historic lows in those markets.
However, in their exuberance to chase growth opportunities in these markets, many real estate investors ignored the key supply-side risks that these types of markets often experience, including:
- There is generally ample developable land in these secondary markets compared to more densely populated gateway cities like Los Angeles, which were largely developed in the decades after World War II.
- Because developable land is not as scarce in the secondary markets, it is much cheaper to acquire, resulting in more sites that pencil out for new construction.
- These secondary markets generally have fewer regulatory barriers to new construction. This makes it easier and much quicker to build new apartment buildings relative to more developed cities where the entitlement process alone can take several years before construction can begin.
These factors together result in the potential to add substantial supply relatively quickly in the secondary markets compared to the larger, more dense cities such as Los Angeles. This, in turn, can result in an oversupply, reducing both occupancy and rental rates. Combined with less demand characterized by the larger, higher growth markets, previously expected returns can decrease substantially.
In other words, in frothy times, we often see investors lose their discipline and forget that things can easily get worse rather than better in the relatively short term, particularly in secondary markets. This is why it is critical to focus on differentiating relative value across various markets and product sectors—something that is so important for long-run success in real estate investing.
We saw this happen during the pandemic in 2020 and 2021, where there was no meaningful pricing difference for comparable assets in secondary markets like Phoenix or Dallas, where there is considerable supply-side risk compared to cities like Los Angeles, a chronically supply-constrained market where land is scarce and the barriers to new construction are high.
Overly optimistic investors seemed to forget that most real estate markets go through cycles of economic expansion, followed by more development, usually fueled by easy access to low-cost capital. Unsustainable exuberance typically ensues, leading to asset bubbles that eventually burst, resulting in excess supply and insufficient demand. During such downturns, investors have a much lower risk tolerance and there is inevitably a repricing of assets downword. This will eventually be followed by a period of recovery where there are attractive buying opportunities as economic conditions improve.
As Warren Buffet famously said, “when the tide goes out, you see who’s swimming naked.”
We believe that 2023 and 2024 will see the tides go out in many of these high-growth secondary markets that were considered the recent darlings of institutional capital during the pandemic-era.
In fact, we are already seeing this happen in many markets.
Investor expectations about growth and risk are changing. This is causing a pause—sometimes an outright contraction—in debt and equity capital flows. In response, cap rates have already risen by 50 to 100 basis points or more in many markets as debt rates have increased and the likelihood of recession on the horizon.
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No Two Cap Rates are Alike
Once again, we want to reiterate that no two cap rates are alike. Buying an apartment building at a 4% cap rate in Los Angeles is a lot different than buying a similar property at a 4% cap rate in most secondary markets. On paper, these investments may seem similar. However, when a downturn occurs, the stark differences in the fundamentals underpinning these investments becomes apparent.
Historically, cyclical markets like Phoenix and Dallas are battered during economic downturns. Particularly when interest rates are rising. Properties are impacted by lower tenant demand and excess supply, which causes rents to drop and vacancy to rise. Declining cash flow and heightened uncertainty causes risk tolerance to wane and cap rates to increase, which result in lower valuations and, oftentimes, refinancing challenges.
The impact on invested equity can be huge.
Assuming NOI stays the same, a 100-basis point rise in cap rates from 4% to 5% results in a 20% decline in asset value. With 70% leverage, that’s a two-thirds decline in equity investment value.
Now, factor in a simultaneous 10% decline in NOI—which is not uncommon in secondary markets during a market downturn. This can cause invested equity to evaporate entirely.
Let’s compare this to the typical apartment building in a gateway city, like Los Angeles.
In our experience, investing in Class B/C apartment buildings in Southern California provides much greater downside protection, and therefore, better insulates invested equity.
That’s because these buildings have unique attributes and are located in unique markets. For example, Class B/C apartments provide an essential need—workforce housing—in L.A.’s chronically supply-constrained market. These apartments attract what has become a permanent renter class - those who have long been priced out of homeownership (even before interest rates increased) and Class A apartment properties. Our tenants have few other housing choices nearby, particularly at a relatively affordable price point, often half the price of Class A apartments, and near their jobs. As a result, our SoCal properties tend to stay 95-98% occupied, even during a downturn.
Moreover, we target assets with a significant loss-to-lease. The average apartment building we acquire has in-place rents that are 20-30% below market average. Therefore, even if market rents dip during a recession by 10%, we have an opportunity to increase rents while still remaining below market rates. This durability of cash flow is rare and unique to the SoCal market, and gives us a pricing power that simply does not exist in secondary markets like Phoenix and Dallas.
Finally, we utilize debt conservatively. While there may be plentiful and cheap debt capital during periods of market expansion, we realize that the market cycles do happen and we want to be prepared accordingly. Therefore, we typically fund our investments with substantial equity, rarely borrowing over 50% of total capitalization (debt and equity), inclusive of acquisition and renovation costs. We favor fixed-rate debt that aligns with our anticipated hold period, thereby minimizing the risk of rising interest rates.
Given the underlying strengths of the SoCal market described above, while we may have acquired SoCal-based apartment buildings at a 4% cap rate, just as other investors may have bought similar properties in secondary markets at similar cap rates, we are much more confident that we have protected our invested equity in our SoCal properties compared to those other markets and can look forward to future growth.
Conclusion
No investor is bigger than the market, and market changes, whether macro or micro, will affect all of us. Cap rates are increasing in Southern California. However, based on the factors that we outlined above, we have the pricing power to increase cash flow and value, even if we need to weather an impending recession.
We speak from considerable experience here.
Of the 90+ U.S. apartment investments we’ve made to date, more than half have been in Southern California. We continue to double down on this market as it has proven to be among the best-performing strategies across the $7 billion of real estate investments we’ve made over the past 30 years.
Are you ready to invest in SoCal real estate? Contact us today to learn more about Paladin’s Class B/C apartment strategy.
