01/18/2022
Many operators underwrite a baseline cap rate expansion for their investments, underpinned by the belief that the required rate of return will increase per year of hold time, due to a myriad of factors. I think this is great, but this assumption encompasses much, much more.
Ask your operator ‘why’ they are decompressing the cap for a particular investment, or alternatively, why are they assuming it to be flat, or ‘why’ they are underwriting a compression from start to finish. In other words, determine if the sponsor has truly done his homework. In my experience, many sponsors cite it is simply a ‘rule of thumb.’ Do you see the problem with this? If a sponsor cannot explain the factors or inputs that create a critical output known as the capitalization rate, how can they expect to be confident in their deal? How can they expect their investors to trust them?
My initial thoughts on the current/near-mid term inflationary environment and how it influences my logic for capitalization rate assumptions:
1) I am anchored in the belief that Fed is pinned and cannot do much to combat inflation. Why?
a. Raising rates 100 or 200 bps will not make the slightest dent in our federal debt hole – inflation is nearing or hitting double digits year over year (CPI is flawed in nature, by the way, and I believe that we have not seen the bulk of inflation, it is still yet to come)
b. 1/3rd of CPI is derived from ‘owner’s equivalent rent’ – a distorted metric seemingly nobody is aware of
c. The Fed would need to raise rates to 7% or 8% to help combat inflation, but this would cause major economic turmoil. If they do this, the government’s annual debt service would be larger than Medicare, Medicaid, and our Military Budget combined. The Fed currently spends 5% of its annual budget just to pay our debts.
d. Rising rates are incongruent with the Treasury’s goal – raising rates slow inflation, and the Fed needs inflation to assist in eroding their debt.
e. Raising rates would increase our current affordability problem. Folks wanting to become homeowners would be forced to become renters for much longer because their wallets simply cannot afford a large increase in payment. 2/3rd of Americans with a mortgage are locked in under 4%.
f. My Hypothesis: rates will not climb much further than a couple hundred basis points, at most, over the next five years. Single family home values will decrease considerably in 2023-2025 on a selective, micro sub-market basis in areas with real population decline. These declines will be more drastic in micro areas of over-supply. Sub-markets with a healthy supply & demand picture, supported by data, will still thrive amidst rising rates.
g. My Conclusion: multifamily apartment demand will remain strong in 2022 and beyond in areas with balanced supply and demand. I believes caps will further compress in 2022 as there is too much yield chasing historically safe assets *apartments*. My mid-term outlook is that caps will flatline in select micro locations. You cannot print 40% of a nation’s money supply in 12 months and expect nothing to happen. There is too much currency in circulation, chasing assets and markets that investors perceive as “safe.” For apartments located in poor locations, detached from economic drivers, I expect to see cap rates rise considerably over the next 1-3 years.
2) Later next week, I will post part 2 of this discussion. I will talk in more detail about micro supply and demand, speed and abundance of capital, real versus nominal gains, future trends that may influence our industry/cap rates, and how all of it ties into our 2 target markets of focus and overall investment strategy. Cap rates are not exclusively tied to interest rates. I will also reveal Legacy Park’s cap rate underwriting assumptions to conclude my thought discussion.
