Cap Rate Compression Big Time??

[Jason Merchey]

I received an investor summary from a very reputable, perhaps "slightly conservative" operator in the MF space. In this offering, the "average annual return" is 10%. They don't calc IRRs, but frankly, with a 1.7x equity multiple over 7 years, I'm not sure that the nature of an IRR would even increase that to 11%!

Anyway my question is, are you seeing IRRs that low on Class A and B multifamily syndications -- when operators can get sub-3%-interest rates? When apartments are expected to have a banner decade? And I'm not talking about primary markets like LA or DAL, talking about cities that are secondary or gateway markets. 

Boy if this projected return IS inclusive of the gains upon sale (and I did ask the sponsor that question promptly by email), then we are talking about some very notable and disappointing cap rate compression, huh?! I can't quite imagine why you'd send out projections that don't take into account the gains upon sale, but then again I can't quite picture a very reputable sponsor putting out a 10% return apartment syndication, etiehr!

No this sponsor is not greedy and is not taking like 40% of the profits. They are conservative in that way as well.

I'd love to hear from @Brian Burke from Praxis Capital and @Travis Watts from Ashcroft Capital to see where you're projecting IRRs in late 2021.

[Brian Burke]

Addressing the title of the thread, yes, cap rates are compressing big time.  As I frequently say in my book, blog posts, and forum posts, cap rates are simply a measure of market sentiment.  When (insert type of income-producing real estate here) becomes more popular, buyers are willing to pay more, which means cap rates go down.

There are three primary forces at play here.  1) falling interest rates make debt cheaper and makes real estate more attractive.  2) rent growth gives buyers hope that the income stream they are purchasing will grow over time.  3) poor performance or perceived risk of other investment vehicles increase the desirability of income real estate, meaning a lower cost of equity capital for real estate buyers.

Expanding on point #3, the worse other investment vehicles perform, the less investors demand from their real estate investments.  For example, if savings accounts were paying 6% interest, an investor would require a higher return from their real estate investments than they would if savings accounts were paying 0.06%. 

Right now, many investments aren’t paying a very high return. Thanks to rent growth and a long bull market, real estate is often seen as less risky.  Combine those two factors and investors are willing to accept lower returns than they used to. 

Back in 2009-2011, I couldn't get the attention of investors for any real estate strategy forecasting IRRs of less than 20%. Cap rates were in the 7's and even 8's. In 2015-2017, investors got interested at the 15%-18% IRR level. Cap rates were in the 6's. Last year I raised $50 million in a fund forecasting IRRs in the 12%-14% range. Cap rates were in the high 4's to 5's. Today I could probably be successful raising in the 11%-13% range (for newer stabilized class A, this could probably be closer to the 10% range). Cap rates are in the 3's.

Now there are plenty of groups out there buying at these cap rates but still forecasting mid-teens IRR. Most often they are able to underwrite to this because they are using high leverage. Higher returns are out there, but it requires a high degree of risk to achieve it. In my opinion, this isn't the time to be layering on risk. Take the lower returns, and do it with lower leverage. As I've said many times when speaking about navigating markets, "in order to thrive, you must first survive."