The capitalization rate, commonly known as a “cap rate,” is the standard measure of expected return within the world of multifamily investment. A cap rate is an important indicator of performance potential because it factors in both the asset’s price and the net income generated by that asset. As an industry-standard, cap rates allow clear comparisons over time between different geographies and asset types. Cap rates also allow us to test one of the basic tenets of investment theory and answer the question, “Do multifamily investors receive greater returns for greater risk?” Here, we’ll define the historical relationship between risk and return within multifamily through the lens of cap rates and establish expectations for the future of multifamily returns.
Asset Risk in Multifamily
Asset risk in multifamily is a function of an individual property’s location within a neighborhood and the physical qualities of that property. To easily compare asset risk, multifamily professionals categorize properties using three asset classes. “Class A” assets are typically located in favorable neighborhoods, and are newly constructed or thoroughly renovated with luxurious unit interiors and amenities. “Class B” assets are usually located in nondescript areas, are older construction, and have modest unit interiors and amenities. “Class C” assets are typically located in less-desirable locations, are often in poor physical condition with respect to age, and have mediocre unit interiors and amenities. With increasing asset risk from Class A to Class C also comes rising cap rates. In 2019, commercial real estate brokerage and advisory firm CBRE reported that Class A assets within the U.S. transacted at an average cap rate of 4.99 percent, Class B transacted at an average of 5.37 percent, and Class C at an average 6.10 percent. With increasing asset risk from Class A to Class C investments, these cap rates show a 1.11 percent risk premium and support the general theory of a linear relationship between risk and return.
Location Risk in Multifamily
While neighborhood location is a component within asset risk, we allocate location risk to the economic health of specific cities or markets. Markets with a diverse, large, and growing employment base, like Dallas-Fort Worth, are inherently less risky than markets with a declining population, like Pittsburgh, Pennsylvania, or markets with a high concentration of employment within one sector, like the tourism-dependent economy of Las Vegas. Historically, multifamily investors consider the six “Major Metros” of New York, Boston, Chicago, Washington, D.C., Los Angeles, and San Francisco as the least risky American multifamily markets due to their robust populations and diverse employment bases. Opposite Major Metros in the risk model are “Tertiary” markets, or small markets with less than 1.5 million people, and typically require a significant risk premium for investors. The following figure illustrates this premium over the past two decades in the U.S. multifamily market.
According to Real Capital Analytics, since 2001, cap rates within small Tertiary markets average 1.3 percent greater than the Major Metros. Generally, greater location risk requires greater returns. However, the assumption of a linear relationship between location risk and return does not always hold. In the past ten years, the population growth rates within the Major Metros have significantly declined and even turned negative, as is the case for New York, Los Angeles, and Chicago during recent years. Despite these worrying fundamentals for multifamily demand, the risk premium between the Major Metros and Tertiary Markets appeared steady. By the end of 2019, the capital market’s slow reaction to this apparent mismatch between risk and return became evident. According to data provider Real Capital Analytics, prices in Non-Major metros increased 11.2 percent for the year, while prices in Major Metros only increased 3.9 percent. Over the next decade, CONTI expects investors to continue favoring Non-Major metros, specifically throughout the southern U.S., as the capital market responds to shifting location risk expectations.