A Tumultuous Multifamily Market Starts to Reach Consensus on Values

The conclusion comes from CBRE (CBRE)’s multifamily metrics report for the fourth quarter of 2023, authored by the brokerage giant’s chief economist, Richard Barkham; Matt Vance, its head of Americas multifamily research; and Travis Deese, associate director of Americas research. 

“As you get higher cap rates, you get lower values, but because cap rates are increasing at a decelerating manner — less and less each quarter — that means corresponding values are starting to stabilize,” explained Deese in an interview with CO. “You’re not seeing an acceleration of value decline, and with the reversal of Fed [interest] rate [policy], we’ll see a corresponding direct impact on cap rates.” 

The average prime multifamily going-in or “entry” cap rate — the yield on cost that sponsors calculate at the time of purchase — has increased 170 basis points to 5.06 percent since the first quarter of 2022. But the pace of that increase in the average entry cap rate has noticeably slowed over the last year: Entry cap rates increased by 135 basis points between April 2022 and March 2023, compared to an increase of 57 basis points between December 2022 and December 2023. 

Vance noted that the decelerating increase in entry cap rates indicates “a cautious market sentiment” for multifamily, which has been hammered by climbing vacancies, lower occupancy rates, and lower rent growth across markets.  

“What has happened in the last couple of quarters — cap rates up, prices down — is what we’re seeing in other areas of multifamily fundamentals, whether it’s rent growth or occupancies, is that things are deteriorating,” explained Vance. “Cap rates are going up, but they’re going up at a slower pace each quarter, so that tells us things are stabilizing.”  

CBRE’s analysis also pointed to the challenges investors and lenders face in underwriting multifamily projects that cost more to finance than they are forecasted to earn from rents and market value. 

“It’s more difficult today to underwrite negative leverage, where the coupon rate on the loan is higher than the going-in cap rate,” said Vance. “Folks could do that in 2021 because rent growth was so strong. Today, the appetite and tolerance for negative leverage is much lower, which is putting less downward pressure on [going-in] cap rates, and higher borrowing costs are putting upward pressure on those same cap rates.” 

The cap rate spread between entry and “exit” cap rates — the cap rate a project is expected to yield upon sale — declined in the fourth quarter to merely 11 basis points, the lowest spread since CBRE began this quarterly data survey in 2014. The spread between entry and exit cap rates stood at 76 basis points in April 2022, 36 basis points in December 2022, and 27 basis points in March 2023. 

As capital markets push entry cap rates up, albeit at a slower pace, an expectation of future interest rate cuts is driving exit-cap rates down — as investors forecast improved metrics under lower interest rates in the future — creating an ever tightening spread.  

“For it to be the lowest it’s been since the survey began 10 years ago speaks to the challenges that buyers face today, particularly with cost of capital, their borrowing costs,” explained Vance.  

“[Those challenges] have brought those going-in cap rates up to the level of their exit cap rate expectations, and all the Fed posturing and confidence we have of interest rates coming down are giving folks more confidence in the future, which is putting downward pressure on the exit cap,” he added. 

Both Vance and Deese emphasized underwriting metrics for multifamily should improve across the board in 2024, especially if and when the Fed cuts interest rates as many as three times — as Federal Reserve chair Jerome Powell recently indicated would happen. Cap rates have already inverted in Chicago and Washington, D.C., reflecting market stabilization and confidence investors have in those markets going forward. 

“We’re not there yet, but because they’re expanding slightly, but because they’re increasing at a slower rate each quarter, we’re feeling more and more confident with each additional data point we receive,” said Vance. “They will peak, now or soon, and, on the back of Fed rate cuts, with more stable interest rates, we can expect more stable underwriting metrics, as well.” 

Brian Pascus can be reached at bpascus@commercialobserver.com