Written by: Greg Johnson
Apartment prices are at record highs due to a “perfect storm” of contributing factors. Low interest rates, high rents, and low vacancy rates all help push values up. But the X-factors that have CAP rates so low and prices so high are stability and predictability. It’s one thing to have favorable conditions, but it’s so much better when you can expect those conditions to remain for an extended period of time. The result: Investor Confidence!
As long as investor confidence remains high, so will prices.
Today, interest rates are near 4%, and we’ve seen CAP rates near 5% in Central Denver this year. (Remember, the CAP rate is the return an investor would get if he bought his investment for cash.) Historically, CAP rates for Denver apartments have been 1.5 percentage points to 2.0 percentage points higher than interest rates. The fact that they are only 1 point higher than interest rates is a combined factor of high investor confidence, low interest rates, and predicted stability in the Denver market through 2016.
But what happens if investor confidence begins to wane? What if, say, interest rates begin to increase? Let’s take a look…
If interest rates rose in the next year, it would likely impact investors’ confidence in the market. They would react negatively to the change. Investors would demand a higher return on new investments, meaning that CAP rates would rise. We would expect if interest rates increased from 4% to 5%, that CAP rates would rise from 5% to 6% (at least). That would have a dramatic impact on values!
A 16-unit building valued at $2,000,000 in today’s 5-CAP market, would be worth only $1,666,667 in a 6-CAP market. That’s a 17% drop in value!
It’s not to say that investors should be nervous. To the contrary – – very few people are predicting a dramatic interest rate increase anytime soon. But what goes down, must come up – and when interest rates inevitably rise, the impact on apartment values will be real.