Cap Rates vs. Interest Rates

by Joe Hornstein

The question we have been getting asked most frequently by our clients lately is how higher interest rates will impact property values in the short term.  While there are many market factors that could impact the answer to this question, here are some general thoughts.

If interest rates go up and rental rates remain flat, values should go down, but that doesn’t mean they will.  Interest rates are currently about 1% higher than they were earlier this year, yet capitalization rates on recent Class C multifamily investment sales remain consistent.  As an example, if an investor obtained a 75% LTV loan to purchase a property at a 6% capitalization rate at the beginning of 2018 when rates were around 4%, they would have expected to realize a projected cash-on-cash return of 6.81%.  Now, if an investor obtains a 75% LTV loan at the same 6% capitalization rate at current 5% interest rate, the projected cash-on-cash would decrease to 4.67%, a difference of around 30%. Further, if that rate were to increase to 6% in the future, the projected cash-on-cash return would be 2.42%, a difference of around 65%!  We have seen capitalization rates continue to decrease over the last several years, so its possible investor demand and a lack of a more desirable financial investment vehicle (real estate vs. stock market, etc.) will continue to help investment real estate overcome conventional wisdom.

The contrarian view to this theory is that if rental demand remains high due to continued absorption of new apartment units and lack of affordable homes to purchase, which are both happening right now, rental rates will continue to increase and offset any potential downside risk associated with higher interest rates.  Given that we believe Denver is here to stay as a Tier One real estate market, we believe this will come to fruition long term, especially after new apartment construction has significantly decreased and returned to a normal level.  However, we are starting to hear some interesting feedback that has us a little concerned in the short term.  Just last week, we met with a potential new hire who just moved to Denver from out of state and rented a new Class A 1Br/1Ba apartment located in the Highland neighborhood with amenities that was advertised for $1,600/month for an effective rate of $1,200/month after factoring in 3 months of free rent included in the lease.  Since we typically broker Class B and C properties, this news was shocking to us.  We are seeing Class C properties in outlying suburban areas like Aurora or Lakewood renting for around $1,000.  If the delta is roughly $200/month between Class A apartments in Central Denver with new amenities, compared to $1,000 for older building, with little or no amenities in suburban areas, how long will it take for concessions to trickle down to our market?

Based on summary above, if we see interest rates continue to creep higher or we begin to see rent concessions being offered on Class C buildings lowering the net effective rent collected, it would likely have an impact on overall investor demand and potentially property values.  If both happen and rents stay flat or only realize minimal growth, it could significantly impact property values.

We definitely believe in the Denver apartment market long term, but we also believe that of our clients should understand how changes in the market could impact their property values in the future. Whether you have an immediate need or not, it’s a good time to get a free property valuation from our team to stay informed.

Hornstein Fetter Team