Multifamily bubble to pop?

Victor Calanog, director of empirical research, Reis Inc.

As published in Scotsman Guide's Commercial Edition, September 2008.

For brokers, the multifamily sector is fraught with questions. Did these properties transact at inflated prices in recent years? Or were they insulated from the froth that characterized single-family-price gains?

The answer will determine if multifamily properties will end up with the same problems afflicting the residential sector -- price deflation and increasing defaults and delinquencies, important factors that commercial brokers must consider in pricing their offerings.

The relationship between a multifamily property's underlying value and its transaction price is fairly straightforward: If the buyer earns enough net operating income (NOI) and residual value upon disposal to justify the required returns from the investment, then the price reflects the asset's value correctly.

One measure often used in industry to capture value is the capitalization rate, obtained by dividing NOI by the sales price.

As noted in the graph, multifamily cap rates declined from 2005 to the third quarter of 2007, driven by increasing transaction prices. Falling cap rates imply that NOI growth was not keeping up with the transaction-price increase. If NOI grew at the same rate as transaction prices, cap rates would stay flat.

Buyers kept these transaction prices up for one of two reasons: They felt they could fetch even-higher prices from a quick resale, or they felt they could earn higher NOI in a buy-and-hold strategy.

Cap rates and transaction prices flattened in the third quarter of 2007, the quarter that marked the beginning of the credit crunch. As of the first quarter of 2008, we have observed price declines of almost 15 percent from their peak of $110 per square foot in the third quarter of 2007. Given the uncertain economy, there are lower expectations for higher resale prices and substantial NOI growth to justify high transaction prices.

With the prospect of mounting job losses and a general economic slowdown, brokers would be well-advised to be more thoughtful and realistic about price and income appreciation in the multifamily sector.

Victor Calanog, director of empirical research at Reis Inc., writes a monthly column on property types for Scotsman Guide. As head of Reis' core economics team, he is responsible for data models, forecasting, valuation and portfolio services for clients in commercial real estate. Reach him at victor.calanog@reis.com.