Is There An Apartment Market Bubble? Interest Rate Impact

Multi-Housing News published an excellent article this week that asked a simple question; Is There an Apartment Market Bubble? It was followed with three answers from various participants. All three respondents agreed that there was no apartment bubble, but I'd like to review the answer I found most interesting (because he was closest to the correct answer). First we'll begin with the question:

MHN: In many of the top U.S. markets, apartment pricing appears to have returned to, or be close to, peak levels achieved in 2007. In certain cases, cap rates are once again sub-4 percent. Is there a possibility of a bubble developing in multifamily real estate driven by the low cost of capital, low yields in alternative investments, aggressive projections of apartment incomes in valuation and/or any other factors?

And the response from Ray Huang, Independent Research Firm:

"We do not currently see a bubble in apartment values. If our forecasts for apartment rent growth prove accurate—and we forecast positive, but decelerating rent growth over the next several years—apartment values look to be in proximity of fair value, maybe even a little cheap. Our main benchmark is the fixed income market. Unlevered IRR premiums to 10-year Treasuries, BAA corporates and high-yield bonds (a case can be made to compare return hurdles to any three of these indices) are all in-line or larger than historical averages. If we are in a bond bubble—and we don’t pretend to be smart enough to answer that question—then yes, apartment asset values may be inflated. However, if such proves to be the reality, a lot of other asset classes may also be inflated, not just apartments or commercial real estate in general."

Analysts such as the one above measure the cap rate spread against the 10 year treasury. Based on where treasury bond (federal government bond) interest rates are today he feels that apartments are being correctly priced and in some cases are still undervalued. The only problem would be the unlikely "black swan" type event of treasury bond rates rising. If this were to occur then apartment values would plunge.

This is exactly what is coming to the market. Hundreds of billions in capital are once again pouring into the real estate sector because they are chasing price momentum and they are chasing bond yields down. I can imagine an analyst approaching the owners of a real estate investment trust and showing them a few quick models of what would happen if interest rates were to rise just a tiny amount. They are probably thrown out of the room with laughter as analysts were back in 2006 when they ran quick calculations on subprime residential loans with questions like "What would happen if interest rates rose?" 

Unlike residential single family real estate, the recent hysteria in the apartment market and purchases of these buildings at insane price levels means we are much closer to the top than the bottom.

For much more on this discussion see the 2012 Commercial Real Estate Outlook.