René Nelson with Pacwest Commercial Real Estate asks the expert Zoe York, MAI Appraiser with Duncan and Brown, about market rate trends and cap rate trends for multifamily properties in the Eugene–Springfield Oregon area. They look at uncertainty and the lag rate between rising interest rates and rising cap rates as well as the thriving campus multifamily market.
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René Nelson: What are you seeing for cap rate trends for multifamily in the Eugene, Springfield area?
Zoe York: In general we saw a huge increase in cap rate trends during the recession, not just for multifamily. Then, starting in about 2014, we began to see a steady decline. That sort of leveled out last year. We hit fairly low lows on all of our cap rates in 2017 and we’ve seen more stabilization in 2018. I expect cap rates to stay stable into 2019. Then, there’s a little bit of uncertainty in our market as to what’s going to happen mid to late 2019 and moving forward. A lot of that uncertainty is because of rising interest rates. That is a bit tempered by having a market in which we’re in a major undersupply situation, particularly in multifamily, but also in some of the other property types.
Zoe York: We also have very limited land availability and rents are increasing. On top of that, we have a lot of investors looking to put money places. You have undersupply in terms of your tenant base, and you also have undersupply in terms of properties available for purchase. All of that puts downward pressure on cap rates and upward pressure on prices. Even in a climate where interest rates are starting to rise, you still have a very, very high demand. I think that’s going to keep cap rates stable in the short term, but ultimately rising interest rates will result in rising cap rates.
Zoe York: I don’t have the answer to this, but the question is how long that lag period will be. How long will our undersupply and overall market demand temper these cap rate increases? My general feeling based on what I’ve observed in talking to people and looking at the market is that we will see stability in our cap rates over the next year. Then the question becomes what the impact will be and the magnitude of it as interest rates rise.
René Nelson: How do you factor in the uncertainty, but also kind of knowing what the projection will be for, say, six months down the road? As you’re doing an appraisal today, how do you factor in six months down the road? I also know you look in the past, so talk to me about that process because I know you do a lot of analysis trying to read the tea leaves.
Zoe York: The tricky part about cap rates is that even though they are a point in time measure of risk, they actually are meant to inherently reflect risk over a projection period. Even though it measures only a single year’s income, it inherently reflects the market expectation for change. What that means is that if you purchase a property today and I see the cap rate of your property as of today’s projection of next year’s income, that rate should inherently reflect your investor expectations of what the changes in the market might be. The challenge with that is, even though all the cap rates that I might see, if everything sold today, every cap rate should inherently reflect that market perception for change moving forward.
Zoe York: The challenge is that as sales volume decreases, for example, if everything sold today and I appraised property six months from now and I didn’t have any sales between now and six months from now, I’m using cap rates that reflect market expectation of change from six months prior. As I said, in a market like this, cap rates might stay stable for a year. Well, there’s going to be more expectation for change six months from now. That’s always the challenge as an appraiser is looking back. I’m using data looking back, not forward. I have to take into consideration that that date of sale might not reflect the true market expectation for change.
Zoe York: I can’t make things up. I have to use a supported valuation. I’m still using those sales and I can use my best judgment. I can talk to brokers. I can use other market trending data that might be more recent. I can try to project out what’s going to occur and how that risk should be assessed in the context of the data that I have, but it’s always a tricky game, particularly in a market that’s rapidly increasing or rapidly decreasing. Essentially, I have to use my best judgment, but I’m always stuck using sales in the past. That’s always going to be a challenge in being an appraiser and using appraisals in a changing market.
Campus and Multifamily Properties Eugene
René Nelson: Talk to me about campus. I know the University of Oregon has always been on the radar of the national student housing developers. Also, we have a lot of 10- to 20-unit complexes from the 1970s. What are you seeing for cap rates for the campus area?
Zoe York: Truthfully, the campus area has not historically shown a huge variance in cap rates in terms of the larger market area. We did see lower cap rates right in the 2014–15 era when these brand new complexes were selling. I didn’t necessarily think we saw that because it was campus, but It was more because these were newer buildings. It all comes down to the characteristics of the income, not necessarily the location, but the location does drive the income projections. Now I’m seeing cap rates for campus being just the same as cap rates marketwide. The differences arise from the age of the property, the location of the property, and the risk to the income.
Zoe York: If you have a campus property that’s older—not 1970s older, but maybe 2006 older—and it’s on the western fringe or on some other fringe of campus, then that is going to be higher risk because those properties have rents at the upper end because they’re newer, but they’re on the older end of the newer properties. They’re also in an inferior location. That is the highest risk property in terms of your campus sub-market. That might have a higher cap rate, but it’s not necessarily because it’s campus. It’s because of its location and its rent characteristics and its risk characteristics.
Zoe York: Generally speaking, I’ve seen very high demand for smaller, older properties on campus, both in terms of rent demand and also in terms of investor demand. The larger ones—let’s call them purpose-built projects, like The Hub and 2125 Franklin—those have been kind of their own little sub-market. They tend to operate on lower occupancy than the rest of the market, but they also drive down overall campus occupancy. The campus vacancy factor was 2.7 percent last year and 3.1 percent this year. Most of that vacancy is in these larger purpose-built projects. I would say the smaller, newer, locally owned and operated projects have only about a 1 percent vacancy factor right now—or less.
René Nelson: I know a lot of the multifamily owners that own the 1970s stuff on campus, and they don’t want to sell because they’re able to increase those rents every single year. As you know, most students only stay in a place for a year; either they have a roommate they don’t like or they want to room with somebody different. They typically transition every 12 to 18 months. Interestingly enough, one thing that I see with a lot of investors is that not everybody has that appetite for the campus market. They’re afraid of student housing or they have to solely rely on a property manager to manage that property for them because of the inherent risk. What’s your thoughts on property management and student housing? Do you still see that most of those 1970s properties are professionally managed? Or are some self-managing?
Zoe York: With the older properties there’s definitely a mix of owner managers and professional management, just like there is in the larger market. What I’m seeing more frequently is the need for professional management in apartment complexes. If you’re looking at a duplex or a smaller property, then owner management is really not a big deal. It tends to be a pain because you’re dealing with students but I know several people who do own their own duplexes and single-family properties and they manage them themselves, but it can definitely be a challenge.
Zoe York: When you get to five units and more, I see more and more that professional management is important. It’s not just in the campus market. For the campus market, it tends to be important because of the timing of leasing. When there are a lot of students coming to the market and you don’t put your units on the market for lease or renewal in early January, then you’re kind of missing the boat. A lot of people will wait until March or April. I do a campus rent survey every September, but I do an intermediary survey in March, and a good portion of property managers are 90 percent full by March. In terms of pre-leasing for the following year, that really important for professional management. Also in the larger market area, when you have rising rents and low vacancy, it’s important to have a property manager who is keeping their finger on the pulse of the market and raising rents on intervals appropriate with how market rents are rising.
Zoe York: I’m seeing more and more frequently that property owners aren’t raising rents on pace with the market. When that happens, you fall behind the curve and then you’re suddenly $200 or $300 below market and you can’t catch up.