Apartment cap rates can be calculated as the ratio of the property net operating income (NOI) over its market value or price:
Apartment cap rate = Apartment NOI/Market Value
Understanding the major forces that influence apartment capitalization rates can help evaluate developments in the capital and real estate market and assess their potential effect on market cap rates and their subsequent impact on apartment property values and apartment prices.
According to the
latest NCREIF report regarding the performance of US institutional apartment property investments, the total annualized apartment return in the 1st quarter of 2009 was -16.4%. This was the result of an income return of 4.6% and a negative appreciation return (decline in average apartment prices) of -20%. The quarterly decline in investment-grade apartment values was -9.9%.
The apartment capitalization rate represents a required or acceptable income return by investors looking for apartment properties in the local housing market. Within this framework, three major apartment cap rate influences can be identified:
a) Perceived risk associated with the apartment property under consideration,
b) Appreciation expectations, or investor expectations for future apartment value increases
c) Required returns in alternative investment vehicles, such as stocks and bonds
Perceived Risk
In the apartment market,
risk can be defined as the uncertainty with respect to an apartment building's income-earning capacity and value. Investor risk perceptions regarding the prospects of an apartment property are influenced by the economic and apartment market conditions prevailing at the time of the purchase, especially with respect to household income and
population growth, as well as apartment supply growth. All else being equal, one would expect that when the apartment market is strong, with climbing rents, high levels of absorption, and decreasing vacancies, investors will feel less uncertainty about apartment property future cash flows and appreciation prospects. This lower uncertainty will translate to lower apartment risk perceptions, allowing investors to accept lower returns and, therefore lower apartment cap rates.
Besides the effect of broader apartment market conditions the investment performance of an apartment property is also affected by property-specific and location factors. Hence, these location and property-specific factors shape also risk perceptions and the cap rate that may be used by an investor in determining the price he/she is willing to pay for an apartment property. For example, an investor may consider a 30-year-old apartment building as more risky than a new one because of greater risk of functional obsolescence and greater uncertainty regarding the building's required maintenance expenses.
Other location-specific factors that may influence investor risk perceptions have to do with the stage of development of the property's neighbourhood. An investor may view an apartment property located in an area with little development, infrastructure, and supporting services as more risky, compared to an apartment building located in a fully developed neighborhood. An apartment property in a neighbourhood that is at the early stage of its development may have greater value appreciation potential, but there is also greater uncertainty as to whether further development will eventually take place and when. That is why new massive apartment/housing development in a mostly undeveloped area will decrease the risk of existing apartment properties and contribute to decreases in the cap rate investors are willing to accept for and increases in the value of such apartment properties.
Appreciation Expectations
Another factor that may affect an apartment investor's required rate of return, and therefore, the apartment capitalization rate, is expected
appreciation. Investors make their decisions based on the total expected return, which is the sum of income return and appreciation return. To understand how expected appreciation may affect apartment cap rates, consider an apartment investor who requires a total return of 10% on his/her investment. In evaluating a property for acquisition, the investor is told by a real estate advisor that the expected appreciation rate for the property is estimated at about 4%. Given the total return requirement of 10%, the investor will buy the property only if it is priced so that it offers a 6% (ten percent minus four percent) income return, at least.
The bottom line is that when market-wide expectations of value increases are high, apartment capitalization rates are low; when the expectations for value appreciation are low, apartment capitalization rates should be high. Notice that investor expectations regarding the future appreciation of an apartment property are influenced by the same factors that influence risk perceptions, that is, indicators of apartment market strength.
Returns in Alternative Investment Vehicles
Finally, when stocks and bonds are doing better relative to real estate in general and apartment investments in particular, there will be fewer investors and less capital chasing apartment properties. Keeping the supply of apartment investments constant there will be less investors competing for the same number of investments thereby allowing acquisition of such properties at lower prices, and, hence, higher apartment cap rates. Therefore, when alternative investment vehicles are doing better than apartment investments apartment cap rates should be rising.
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Return from Apartment Cap Rates to Capitalization Rates
