What to Expect for Multifamily Cap Rates 2023

Multifamily properties became the hottest investment assets through 2020 and 2021. Investors from global institutions to private investors set their sights on multifamily properties to take advantage of increasing rents and strong cash flow.

As any real estate investor knows, capitalization rates are a key factor in determining the value of a property. And while a number of factors can influence capitalization rates, one of the most important is the overall economic climate. In recent years, capitalization rates for multifamily properties have increased as the economy has strengthened.

Over the past two years, we saw multifamily cap rates dive to record-breaking lows. With the exception of the Midwest markets, the average cap rate dropped with each passing quarter. Most impressively, CBRE’s Cap Rate Report shows that the average cap rate in South Central markets dropped from 6.35% to 4.89%.

But what will we see for multifamily cap rates in 2023?

What are the implications of changing capitalization rates?

Cap rates are a simple metric that communicates net return to buyers and approximate selling price to owners. When a market’s cap rate increases, that tells prospective buyers that they can expect a higher net operating income return. For example, a $1 million asset being sold with a 6% cap rate tells buyers that the NOI is approximately $60,000.

Alternatively, prospective sellers use market cap rates to understand the approximate listing price of their asset. For example, if their asset’s NOI is $100,000 and the market’s cap rate is 5%, they will list their property for $2 million. However, if the market’s cap rate is 6.5%, they will list their property for around $1.5 million.

Multifamily capitalization rates have an immense impact on value and returns. The multifamily cap rate drops we saw over 2020 and 2021 effectively spiked the value of assets across most markets. As a result, motivated buyers were pushed into paying premium asking prices for assets. However, 2022 saw a shift in the wind as interest rate hikes made multifamily purchases increasingly difficult to underwrite and fund.

High-interest rates will hit multifamily cap rates in 2023 hard

Multifamily remains a high-demand asset class, but the rising cost of debt makes it increasingly difficult for investors to justify high cap rates. To accommodate for high-interest rates, multifamily buyers need assets with higher NOIs so that they can be assured that cash flow will cover their debt costs moving forward.

While sellers adjusted their price expectations, sales volumes in 2022 were disrupted. Buyers are now factoring in higher debt costs into their underwriting assumptions and waiting to see more balance in the market. Apartment buyers are looking for higher yields to help justify finance interest rates.

Given that high inflation seems more durable than we expected, the Federal Reserve will continue implementing interest rate hikes into the new year. The continued high cost of debt, a reduced buyer pool, and buyer demand for higher yields will impact multifamily cap rates in 2023.

Multifamily cap rates 2023: projections

Persistent inflation is both a driving force in the multifamily sector and a hindrance to cap rates. Cap rates are a response to market demand, which is heavily impacted by the cost of debt. As a result, while investors face high-interest rates, they will target lower cap rates in their offerings.

A July 2022 Fannie Mae report based on CBRE data provided various cap rate forecast scenarios based on differing economic scenarios. Interestingly, their projected cap rates had minimal variations depending on a moderate to severe market downside. The key takeaway is that while multifamily cap rates in 2022 will increase, we aren’t looking at the average rate jumping above 6% as we saw in 2019. Instead, expect to see the market normalize next year with multifamily cap rates jumping from 5.0-5.5%.

Rising rents will support high multifamily cap rates in 2023

Rising rents will help justify lower multifamily cap rates, despite the high cost of debt. While inflation is forcing the Fed to increase interest rates, it’s also creating rent inflation, which means higher asking rents for multifamily property.

According to the National Association of Realtors, rental rates in September 2022 were 24.8% higher than at the same time in 2019. Rent growth is projected to continue into 2023 as homebuyers are forced out of the market by high-interest rates. Lack of supply remains an ongoing problem in both the residential and multifamily sectors.

Investing in 2023

Multifamily assets still represent incredible value for investors in 2023. Of course, buyers need to take debt costs into consideration, however, motivated investors are targeting markets with strong rental growth and accepting lower returns in the beginning years of their investment.

While multifamily cap rates will increase, don’t anticipate them to skyrocket. Sellers understand the value of their assets and the impact of limited supply. The 2023 multifamily market will bring opportunities for investors who can balance their debt with asking cap rates, and understand that while debt can be refinanced, multifamily prices are expected to continue upwards alongside rents, despite increasing cap rates.

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