Commercial Research

Las Vegas MultifamilyTrends, Fundamentals, Land Acquisition and Development

Spring 2016

Market IQ

Commercial Research Multifamily continued its multi-year run as arguably the most favored asset class by both institutional investors and individuals. Additionally, developers have returned to Las Vegas and are delivering some impressive projects, mostly geared towards the luxury and renter-by-choice market segments.

Clearly developers are responding to fundamentals, which have improved substantially since the recession. Local rent increases in the sector typically surpass other commercial segments, such as office, which continues to lag the recovery cycle and industrial and only recently started a turnaround, albeit with a surprisingly strong drop in vacancies in 2015. Retail remains broadly challenged despite stronger retail sales locally, presumably because some pockets of retail are doing great while other centers remain challenged. Additionally, industry trends are shifting and some anchor tenants had exited the Las Vegas market, including Food 4 Less, Haggen and Fresh & Easy. The volatility and unique property risks in these sectors likely drives some of the interest in the multifamily sector by both buyers and financing providers.

In the prolonged low-yield environment, a search for yield has propelled many categories of investors into the space, including REITs, pension funds, high net-worth individuals and family office capital. There are simply not a lot of options in which to place money that are considered mild to intermediate risk. Similarly, the asset class is perceived favorably by many lenders ranging from community banks to commercial mortgage-backed securities investors, so the cost of borrowing is relatively cheap, preserving some of the spreads despite compressed cap rates.

Mom and Pop investors continue to be interested in Class C structures but these deals have become even more sparse in the Las Vegas market with a widening bid/ask spread. Similarly, Class B properties are paced on the market infrequently and the trades we see are often principal to principal, rather than using the traditional brokerage channels with many marketed as unpriced listings. Additionally, a lot of investors want value-add opportunities, however, many sellers of challenged buildings are pricing them as though they were stabilized. In Las Vegas, the lower-end

YIELD PERSPECTIVES

Globally, yields remain far below historical levels. Many central banks continue to be accommo-dative in the face of weak GDP growth and little inflationary pressure. As a result, many of the lower risk dividend and interest rate instruments remain priced to a low yield.

To achieve high yields, one must either move abruptly on the risk spectrum (emerging markets or junk bonds for example) or accept lower liquidity (real estate). Given some of the vanilla choices, it’s not surprising commercial real estate has been receiving a lot of interest.

Figure 1Relative Yields Across Asset Classes

segment of the market is largely broken with a drought in listings and many buyers, whom range from professional investors to the largely uniformed. We note just a handful of trades that have occurred within the Class C segment in Las Vegas for 2015. Smaller buildings with less than 100 units get a lot of buyer interest, but often have issues during inspection so we estimate there is a multitude of failed escrows over the transactions we actually see close.

Capitalization rates have been relatively low for several years, with cap rates for Class A Las Vegas properties in the low five percent range on average. Nationally, IRR measures the average U.S Suburban Class A cap rate at 5.48% and the West Region is posting an average of 4.80%.1 Cap rates are so low in core markets that many investors are searching in second tier markets like Las Vegas. Cassidy Turley measured the lowest cap rates in New York at 3.5%, San Francisco at 4.3% and Orange County at 4.4%.2 We also understand sub-4% cap rates have been observed in San Diego. While rental rates and occupancies have long been strong in these areas, Southern Nevada has registered strong improvement as well. It is therefore no surprise that investors have shown interest in Las Vegas. Multifamilyexecutive.com notes that the cap rate spread between core and secondary markets has narrowed from 200 to 300 basis points and down to as low as 50 basis points. Similarly, we have seen Southern California investors get priced out of their market and search in Las Vegas.3

When we think in terms of historical spreads between cap rates and the “risk free” rate proxied by 10 year U.S. Treasury bonds, spreads are still wider than they have been in recent years. In 2006, when nearly everything in the real estate sector was in a bubble, spreads were only about 100

1. IRR Viewpoint: 2016 Commercial Real Estate Trends Report2. http://news.theregistrysf.com/wp-content/uploads/2014/09/Cassidy_Turley_US_Multifamily_Report_2014_Review_2015_Forecast.pdf3. http://www.multifamilyexecutive.com/business-finance/debt-equity/chasing-yield-the-2015-dealmaking-outlook_o

Figure 2Class A and High Quality Class B Going-in Cap Rates

Source: Costar, Clark County NV, Fred II, Coldwell Banker Premier Realty.

Figure 3Las Vegas Apartment Average Asking Rent

Figure 4Las Vegas Apartment Vacancy Rate

Map 1Class A Apartment Occupancy

December 2015 snapshot.Source: Costar, Coldwell Banker Premier Realty.

FUNDAMENTALS

The leasing market is bifurcated between lower quality and higher quality projects. Figure 4 illustrates that significant difference between occupancies in the overall market, which includes a significant amount of Class C projects. If we could also add a new category “D,” that would be in there in the form of smaller and older buildings. We know of at least 300 buildings in the urban core that were built before 1970. If we analyze Class A buildings or high-quality Class B (which we consid-er to be those built after 1990, have more than 200 units and achieve rents of at least $0.85/sq.ft) buildings separately from the overall market, vacancy rates are as low as they were during the boom days of 2005.

Source: Lied Institute for Real Estate Studies, Costar.Source: Lied Institute for Real Estate Studies, Costar.

points. Spreads were probably widest in 2011 and 2012 and with current Treasury yields at 2.06% that is still about 300 basis points for most Class A projects in Las Vegas.

FUNDAMENTALS

The cap rate spread is only part of the story. Improving fundamentals in the Las Vegas region are also added to pro forma gains. Although the Las Vegas MSA has not yet returned to the employment high of 2007, job growth is on the rebound and we are observing some mild wage growth as well. Additionally, both single family rental rents and Class A and B apartment rents appear to be growing. Further, occupancies across the Class A segment are very strong with many buildings in the high 90’s. There is also some evidence that concessions have burned off further with ALN noting that apartments offering concessions dropped by 21.1% year-over-year (Dec 2015 data). The average concession package was 4.4%, down 16.7% from the same time last year.4 4. alndata.com

Figure 5Visitor Volume - Clark County NV

Figure 6Non-Farm Employment - Clark County NV

Additionally, Las Vegas’ major sector, leisure and hospitality, is expected to grow further with the addition of Genting’s Resorts World Las Vegas, which broke ground in May. The project is anticipated to be 3,000 rooms in its initial phase. The project is estimated to support more than 13,000 direct and indirect jobs.5 The Lucky Dragon, a boutique hotel near Allure Condos on Sahara, continues construction. The Las Vegas Convention and Visitors Authority (LVCVA) is also expanding into what will ultimately be the $2.3 Billion Las Vegas Global Business District. As a testament to the strength of the LVCVA’s plans, it purchased the Riviera Hotel and Casino in 2015 and in November 2015 approved a contract to demolish the project to make way for the Global Business District expansion.

We anticipate that added construction on the Las Vegas Strip and Downtown will drive employment back to it’s 2007 high within a short period of time. Unemployment rates remain elevated at 6.3%, however year-5. http://lasvegassun.com/news/2015/may/05/group-says-new-las-vegas-strip-resort-casino-rise-/

over-year job growth is occurring at a faster rate than the U.S average and is 2.6% for the Las Vegas MSA compared to 1.9% for the United States.6 The area was hit disproportionately hard with a combination of a national recession and a deflating housing bubble. Currently, housing

6. nevadaworkforce.com, Nov 2015 data.

Source: Nevadaworkforce.com.

Source: Las Vegas Convention and Visitors Authority.

prices have returned to pre-bubble trends and distressed housing inventory is no longer a drag since the majority of closings are traditional sales. Additionally, visitor volume to Las Vegas has never been higher than it was in 2014 and that strength continued into 2015, a new record year with over 42 million visitors.7 Growing employment opportunities have helped return the area to positive migration and retirement remains a motivation for some individuals.8

Gaming Revenue is not matching the trajectory of visitor volume, revealing a much milder upward trend. Las Vegas has adapted well to changing consumer tastes, with a sizable nightclub scene and a greater focus on maximizing hotel and food and beverage revenues. As a result, gaming, while still important, is of less significance than in the past. For example, MGM Mirage Corporation, which is the largest single operator in Las Vegas and is a good barometer for the region, has diversified on-property greatly. In 1994, gaming revenues were 59% of gross revenue compared to 2014, where gaming revenues were 38% of total revenues. Growing shares of revenue went to food and beverage, hotel and entertainment and retail according to the company’s annual reports.

Total non-farm employment is now almost 12,000 jobs short of its 2007 high. Measured in November, on a year-over-year basis, Las Vegas added 23,000 jobs. If this rate continues, we should be back to peak employment in the next 6-12 months. It has taken a long time to heal the economy and some lingering issues remain, such as rising but relatively weak wage growth (inflation-adjusted) and a prevalence of part-time workers that desire full time work, however, the net result paints a positive picture for the region.

In addition to major gaming projects like Resorts World Las Vegas, we are also seeing non-gaming growth in the Valley with new entrants like Asurion, which provides mobile phone and tablet protection insurance, Catamaran RX in the medical space and manufacturing, including Cannon Safe. Sutherland Global, a business process outsourcing and technology company, is moving into the shuttered Citibank campus in the Lakes area of Las Vegas. 2,000 employees are expected to work at the campus. Faraday, which unveiled a concept electric car at the Consumer Electronics Show in Las Vegas, is expected to build a plant in Apex, an industrial park in North Las Vegas near the I-15. Tony Hsieh’s affiliated VegasTechFund also continues to seed startups and continues to have investments in a large portfolio of companies, primarily in online sales, electronics and education. IKEA, which is opening its first Las Vegas store in 2016, is already hiring. In the summer of 2015, Fidelity National Financial purchased a 22,000 square foot office in Summerlin and this represents some positive absorption for some long vacant space. Barcleycard leased the former Zappos headquarters in Henderson and was anticipated to have 700 employees by now.

Wage growth is not evenly spread out over the employment sectors so Class C will continue to play an important role in workforce housing. There is still significant vacant supply in this category, so we don’t anticipate strong rent growth in the next couple of years. We have observed some owners over-improve for the area but this has not been reflected in stronger rents, implying that building quality is at best a minor premium located within a challenged area.

On the other side of the quality spectrum, Class A occupancies are best described as stellar and several of the newer builds have quality and amenities a step above traditional two-story walk-up buildings. There does appear to be a premium for quality in popular submarkets and those communities with strong walk-ability. Some traditional design projects are achieving rents as high as $1.38 per-square foot for 1-bedroom units. The Gramercy, which is a multi-story, amenity rich mixed-use project, is achieving rents up to $1.80 on 1-bedroom units. The Calida Group has 7. http://vegasinc.com/business/2015/dec/30/las-vegas-set-to-crack-42-million-visitors-this-ye/8. United Van Lines survey reveals that 57% of the moves they facilitated were inbound to Nevada. Further, electric meter hookups, a proxy for household formation, continues in a positive trend.

Figure 7Homeownership Rate - Las Vegas-Paradise MSA

been delivering amenity rich projects with interesting architectural elements and we understand that these recently delivered projects are performing well, indicating strength on the upper-end of the apartment rental market.

The demographic story is positive for multifamily and many expect a higher proportion of future new multifamily deliveries versus single family deliveries nationally. The aging of baby boomers is likely to account for some of this shift in

demand.9 Millennials, are finally seeing some job prospects after many delayed the milestone of moving into their own place. This cohort is generally described as those born between 1982 and 2000 and make up about 95 million Americans. Nationally, Millennials are finally coming off of the extreme weakness exhibited within the cohort during the recession, where the employment to population ratio for 25-34 year olds was as low as 73.4% and after a seven year period, has grown to 76.3% (as of November 2015).10 Locally, developers are tailoring properties to the Millennial market, in addition to empty nesters. Some projects have almost no families with children. Importantly, Millennials have a high propensity to rent. Green Street Advisors estimates that individuals under the age of 35 have a 63% propensity to rent.11

Although it is challenging to define this age cohort, technology, quality gyms and open space appear to be attractive to many Millennials. In leasing, a strong online presence is important. All these features are expensive yet many Millennials are paying for it. While many lack downpayments or credit history to buy a home, high-quality Las Vegas apartments appear to remain in reach judging by the occupancy levels in many of the higher rent projects.

This age group is important because these individuals are the source of household formation for the next several years. The Millennial generation’s peak birth-rate occurred in 1990, many of whom are likely to be renters.12 The generation does have its challenges. Household formations have been held back in recent years by slack in the labor market and likely student loans. A big unknown concerning Millennials is what occupations will be in the next ten years. For example, technology workers are used to moving often and may not like the burden of owning a home, which they would either have to sell or rent if they moved. Additionally, many Millennials recognize that homes can be illiquid and therefore fall into the “rent by choice” category, rather than renting because they lack the ability to finance a home. Employment within this cohort remains challenged but with an estimate of nearly 75 million nationally, this age group is going to define a large share of housing demand long-term.13

The Urban Institute recently released a longitudinal of household formation and homeownership rates, predicting that the homeownership rate would decline through 2030 with the homeownership rate dropping from 63.7% in Q1 2015 to 61.3% by 2030. The study authors anticipate a rental surge of 13 million renters and renters will outpace new homeowners over the next 15 years.14 Projections can often be taken with a grain of salt, however, given that both

9. https://www.kansascityfed.org/publicat/econrev/pdf/13q4Rappaport.pdf10. http://www.axiometrics.com/blog/young-adults-earnings-growth-pace-lags-job-gains11. https://www.reit.com/news/reit-magazine/july-august-2014/millennials-move12. http://www.forbes.com/sites/billgreiner/2015/02/25/how-a-lack-of-income-for-millennials-effects-household-formation/3/13. http://www.pewresearch.org/fact-tank/2015/01/16/this-year-millennials-will-overtake-baby-boomers/14. http://www.urban.org/sites/default/files/alfresco/publication-pdfs/2000257-Headship-and-Homeownership-What-Does-the-Future-Hold.pdf

Source: U.S Census.

Figure 8Multifamily Permits - Clark County NV

government support for homeownership and lax lending in the early 2000’s contributed to an artificially high homeownership rate, the author’s forecasts may have merit.

An additional component of demand in Las Vegas is likely to remain former homeowners who lost their homes through foreclosure or still have tarnished credit profiles due to a short sale. We have observed that many prior homeowners choose to rent single family homes. In the past, single family rental homes were usually held by “mom and pop” owners. Some renters had fear of leasing from an absentee landlord and tended to gravitate towards apartments. Today, many homes are held by institutional investors or firms organized as REITs or are privately owned homes managed professionally by property management firms, so there are many rental options within Las Vegas. The degree to which higher-end apartments compete with single family rentals is unknown to

Map 2Class A Apartment Average Rent Per-Square Foot & Median Household Income

Source: UNLV-LIED,U.S Census.

Source: ESRI,U.S. Census, Costar.

Table 2Under Construction Projects

Table 1Proposed Apartment Projects

PROPOSED PROJECTS

The table above notes some of the projects that we understand could be delivered within the next three years. We are aware of several parcels that are in escrow that are extremely likely to become either traditional apartments or senior apartments, however we cannot mention them publicly at this time. As such, we should not consider the above table to be representative of the entire universe of proposed projects.

us, however we suspect that there is mild crossover and that family size and age of householder remain the primary determinants of who lands in which rental category. Single family rentals are probably fringe competition for the two and three bedroom units in higher-end apartment projects.

Some prior homeowners may only be in the rental market for a transitional period and re-enter ownership after curing credit issues. These are the so-called “boomerang buyers”, of which it is estimated that 700,000 individuals nationally are now eligible for credit again this in 2015 according to TransUnion.15 The principal question is how many individuals are willing to buy or are aware that they can buy. Currently, the pendulum that swings between renting and owning is still swinging towards owning if you examine rent versus mortgage payments on an equivalently sized home. Ultimately, this will be sensitive to mortgage interest rate increases and in theory, renting could become financially equivalent to owning in an abrupt fashion. Many of these individuals and families are likely to be renters for an extended period, gradually trickling back into ownership if the labor market continues to strengthen.

DEVELOPMENT

Following the global financial crisis, both single family and multifamily construction dropped 15. http://www.cnbc.com/id/102773427

Source: Clark County, City of Henderson, Coldwell Banker Premier Realty.

Table 3Recently Completed Projects

Some developers have departed from the traditional two story walk-up/garden style apartments and are building true luxury apartments with a greater variation in architecture, amenities and finishes. The left photo shows Calida Group’s Elysian at The District and DG De-velopment/Fore Property Company’s Volare project, which includes garages and is rare within this market.

sharply. Multifamily construction almost died off completely while many developers focused on broken condominium projects and other distressed deals.

Recently, multifamily permits have been ticking higher but remain low relative to past observations. It is important to note where the activity is concentrated, since success of a particular project is largely determined at the submarket level rather that at the Valley level. Map 3 illustrates where a lot of the recent activity has been occurring geographically. Notice the concentration of projects along the southern portion of the 215, in Henderson near major corridors and on the South Strip. These areas tend to justify projects based on area incomes, proximity to employment centers and are attractive due to major arterial access. Many of these projects are amenity rich and relatively expensive, however there appears to be significant demand for senior housing also and there is obviously a need for affordable options, however this is often determined by land availability and proximity to existing infrastructure as offsites have become quite expensive. Margins may be under pressure as land prices have ticked up for both prime locations and areas for more affordable type projects.

Source: Clark County Assessor.

Map 3Las Vegas Area Planned, Under Construction and Recently Built Apartments

Shown above is Picerne’s project on South Durango and The Warmington Group’s Martin Apartments on Fort Apache. Both projects are located in the Southwest part of the Valley.

One area that seems to have a major deficit in both recent and planned development is in Downtown Las Vegas. Higher-end projects like Juhl, The Ogden, Soho Lofts and Newport Lofts are seeing strong demand for rentals. Of those four, Juhl is the only pure rental project, although originally conceived as a condominium. Both Juhl and The Ogden have had high occupancies and even occasional waiting lists. The owners of The Ogden have been offering units for sale since late last 2014 and a substantial number of closings have occurred. Soho Lofts and Newport Lofts are condominiums which often are used as rentals, so it is challenging to determine the size of the market for higher-quality rentals in the area but there does appear to be a shortage of quality rental units in the Downtown area. We understand that Juhl remains near full occupancy. The Wolff Company has an approved 226-unit mixed-use project on Fremont St, a strong positive for tenants who have often found it challenging to find newer space within the submarket.

Juhl is one of the more sought after residential rentals downtown.

The Ogden has made up a large portion of the Downtown rental pool. Currently the owner is actively marketing these condominiums on an individual basis.

Newport Lofts are individually owned condos, however some occasionally become available for rent. Sale prices have been gradually climbing within the project.

Table 4Rent Price Per Square Foot in Downtown

Source: GLVAR multiple listing service, Costar, Coldwell Banker Premier Realty.*Asking rent. All others are transactions.

Apartment vacancy rates within the redevelopment area are about 10%, which on its own doesn’t sound great. However, when you parse out what those buildings are, the picture becomes clearer. Many of the buildings in the area were built between the 1930’s and 60’s. If we look at some of the more recent buildings from the 1990’s and 2000’s, occupancy is extremely solid with several fully occupied and some hovering between two and six percent vacant. Towards the end of 2014, we examined the financial reports of a renovated apartment project within the Arts District. The property was nearly 100% occupied and had an occasional waiting list. Given what we are observing within Newport Lofts, Soho Lofts, Juhl, The Ogden and the Arts District Apartments, we expect that if a developer could deliver product geared towards urban Millennials, it would fair very well. In some Las Vegas submarkets, we see apartment rents in amenity rich apartments as high as $1,600 for a two bedroom, with several between $900 and $1,200.

The Downtown submarket could probably use a significantly higher supply of modern apartments, especially with more employment centers on the horizon, such as the nearby Resorts World Las Vegas (estimated to support more than 13,000 direct and indirect jobs.16 ) on the north strip, The Global Business District and The Federal Justice Tower which is expected to open soon. Another potential source of renters are the current Zappos employees, many of whom do not currently live in the area but may have a desire to if they can find suitable housing. Additionally, we expect the Las Vegas Medical District will gain some traction.16. http://lasvegassun.com/news/2015/may/05/group-says-new-las-vegas-strip-resort-casino-rise-/

Map 4Apartment Land Sales

Table 5Apartment Land Purchases in the past 18 months

LAND PURCHASES

Based on price per door or price per acre, it is clear that there is broad variation in pricing. It should be noted that most of the high dollar land purchases were by luxury apartment developers, a largely new category in the market.

Source: Clark County NV, Costar, Coldwell Banker Premier Realty.

The single most active submarkets are in the Southwest near the 215 curve and in Henderson near the 215 by both Stephanie Street. and Gibson Road. These areas boast some strong incomes, and favorable demographics and a good supply of developable land in these areas.

Based on what we are seeing in escrow, we can expect significant development in the next few years and this may impact occupancy rates in some submarkets. Nevertheless, we believe that favorable demographics will be in play for most of this forward inventory. As with most projects, it really comes down to the skill of the developer and the leasing team.

* Average Physical Occupancy. MAA reports occupancy at December 2014 and Camden provides the 2014 average.Source: MAA Communities,Camden Property Trust 10-K.

Table 6Public Apartment REIT Las Vegas Buildings

Table 7Sale Panel of Class A and higher quality Class B Apartments 2011 - 2016 YTD

* This sale included undeveloped land.Source: Costar, Powerbroker Confidential, Colonial Properties Trust 10-Q, Clark County, Coldwell Banker Premier Realty.

PERFORMANCE

Map 2 in the fundamentals section illustrates the strong occupancies found in Class A projects throughout the Valley. With occupancies strong and rents rising, it makes sense for developers to move forward with several projects. Additionally, relatively low cap rates are generating more interest by developers, particularly in a national and regional context with both private equity monies and REITs engaging in ground-up development. Camden Properties Trust executives discussed their development pipeline at REITWeek 2015. They are planning 85% of their new pipeline to come from development and repositions rather than acquiring properties. In recent years, they have been selling properties in order to reallocate resources, such as the Oasis portfolio in Las Vegas, which they held an interest in and sold to The Wolff Company. On developments, they noted an expectation of a 7% yield which is substantially better than going out and buying the cap rate, with the exception of having to take both the construction risk and the lease-up risk.

Similarly, Lennar, long known for their single family product, has been developing apartments in recent years and listed 24 communities under construction in Q1, 2015 sold their first two communities in 2014. In this space, Lennar acts as a merchant builder and uses third-party institutional capital on a deal specific basis. Lennar stated in their Q4 2015 earnings call that they completed their Lennar Multifamily Venture, an equity fund which allows them to hold income producing assets in order to have a recurring income stream. They have a pipeline of over 21,000 apartments. Lennar expects to sell 8 to 10 communities in 2016.17 To get a sense of the returns, Lennar stated they expect IRRs to exceed 25% with cash multiples larger than two (Q2 2014 17. http://seekingalpha.com/article/3765836-lennar-corporations-len-ceo-stuart-miller-q4-2015-results-earnings-call-transcript?part=single

earnings transcript). We are not aware of any Lennar apartment projects in Las Vegas but this gives us an idea of what some builders may expect, particularly since Lennar has several projects in high cost California.

While Map 1 gives a sense of occupancies reported by Costar, there are several publicly traded operators which own projects in Las Vegas that provide a deeper sense of occupancies in the region. MAA Communities owns two buildings in North Las Vegas, both acquired through the Colonial Properties Trust acquisition. Camden Property Trust owns 15 Class A and Class B apartments in Las Vegas, each with a reported average occupancy near 95% for most of their buildings. This is probably a pretty good proxy for what a professional management company can expect. Examining the sale panel in Table 7 and in Figure 2, one can see a gradual decline in cap rates over the past several years. Presumably, even projects that traded in 2011 or 2012 may even be valued higher in the market of today. For example, The Croix Townhomes traded in December 2010 for a reported 6.5% capitalization rate and traded

Figure 8Major USD Currency Pairs

MACRO ISSUES

The strengthening of the U.S. Dollar relative to many major currencies may influence foreign developers and present a challenge to property acquisition. For current owners of U.S real estate, particularly by Canadians, this may influence their decision as to whether or not they should re-balance positions or enjoy relatively better cash flow in repatriated terms.

USD/CAD

EUR/USD

AUD/USD

The Gramercy, shown here on the right, is an example of a project originally contemplated as for-sale condominiums and was stalled during the downturn. The project was completed and positioned into the luxury rental market.

again in 2014 for 5.3%. In 2015 there was an apparent slowdown in Class A and B transactions relative to 2014, perhaps indicating that owners are happy sitting on the cash flow or remain bullish on improving rents under continued strong occupancies.

RISKS AND REWARD

Some investors are beginning to question what happens to cap rates in a rising interest rate environment. First, despite an announcement in December in which the Federal Reserve stated they would target short-term rates upward by a quarter point, many Fed observers only anticipate small increases in rates going forward and possibly no increase in March. Additionally, a depressing world wide economic outlook may imply safe haven buying in the U.S. and in doing so keep bond yields from rising. Some positive U.S economic figures, combined with some terrible figures coming out of Europe and Asia further confuses expectations of where bond yields and ultimately cap rates will go.

While many owners use 10-year Treasury rates as their performance benchmark, the relationship between Treasuries and capitalization rates is far from lockstep. Breaking it down further, cap rates are also a function of local supply and demand factors and a cyclical nature of building in many local markets, which don’t all ways integrate well into national models of cap rate and Treasury market trends.

Concerning interest rates, there are a few schools of thought on what needs to be done moving forward. Some market observers believe that a prolonged period of easy money has led to Malinvestment, or the purchase or financing of projects that otherwise would not make sense under most other conditions. As such, they believe that the Fed should attempt rate hikes as part of a “normalization”, despite the potential for shaking out some of the weaker projects. Others believe that the Fed will respond to improving economic conditions, so higher rates will in part be a function of an improving economy. In any case, the natural question remains, will higher rates damage the commercial real estate sector? If indeed higher rates are a function of a better economy, the presumed higher cost of capital may be offset by strengthened demand in the commercial space market and for dwellings. This view may be challenged by observers of foreign markets like China and Europe and the potential for financial contagion.

One cannot look at interest rates and capitalization rates in a vacuum and make broad conclusions. Another important factor is the overall performance of the debt market. John Duca and David Ling (2015) of the Dallas Federal Reserve find that cap rates are negatively related to the availability of credit (more credit availability leads to lower cap rates).18 As a result, commercial real estate prices can be vulnerable to shocks in the CMBS or other capital market channels and this was made more obvious by the global financial crisis. It may also make the case for using, if possible, assumable debt on a building.

Some believe that recent prices are the result more of maintaining reasonable spreads over the cost of capital or performance benchmarks, rather than from lower risk premiums. So while current cap rates may not be predicated on a herd mentality which leads to bubbles, financial market gyrations may lead to a bump in risk premiums built into required rates of return. However, again, if local market dynamics are favorable and investors expect rent increases, there may be an offset there. Additionally, multifamily projects tend to offer some inflation protection in the form of increasing rents, which is harder to achieve in office or industrial buildings which often feature long-term leases at pre-specified rents.

In the end, there are a lot of unknown causalities and non-linear relationships within the world of real estate so making simplified conclusions is challenging. However, examining some of the multifamily REITs that trade publicly, it doesn’t appear as though participants in the equity market are super concerned about long-term interest rates, which affect REITs and other property owners since they tend to use more long-term debt than short-term instruments. Although REITs have been impacted along with the broader stock market, operator specifics appear to be the overriding cause of movement in share prices.19 Further, any individual property can be uncorrelated with the major headlines, at least in a short-run sense.

Multifamily projects tend to have less volatility in net operating income when compared to other property types, hence, lower cap rates in general. Lower cap rates are symptomatic of investor beliefs in how well net operating income buffers against rising rates and economic shocks. As occupancy weakens, landlords can adjust pricing quickly to re-optimize given the new circumstances and then re-adjust over several periods after the economy strengthens. This is contrary to many retail or industrial projects that can lose large tenants altogether, regardless of accommodative rents. So this characteristic of apartments is very positive. Nevertheless, apartments are subject to capital market risk and recent troubles in China and elsewhere point towards a re-evaluation of risk, which in our minds was a long time coming. Federal banking regulators have recently expressed concern about the concentration of multifamily loans within some banks and they are concerned that rising rates could harm the sector. The Comptroller of the Currency, Thomas J. Curry, notes these issues, but also highlights that credit quality hasn’t suffered while demand for these loans has increased.20

Finally, much of what works in the commercial real estate world is derived from intimate knowledge of a particular trade area, along with strong execution in entitlements through construction and lease-up. In Las Vegas, the market seems to be crowded on the acquisition side with little play on the sell side. Additionally, there appears to be further room for well-conceived projects in some submarkets, although several are beginning to get crowded and may influence short-term occupancies.

18. http://www.dallasfed.org/assets/documents/research/papers/2015/wp1504.pdf19. https://www.reit.com/news/articles/reits-outpace-broader-market-january20. http://www.occ.gov/news-issuances/speeches/2015/pub-speech-2015-147.pdf

The information contained in this report is deemed reliable but is not guaranteed. The information and opinions expressed in this document do not constitute investment advice.

Market IQ

Author: John McClelland, Vice President, Research

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