This article was posted on Tuesday, Sep 01, 2015

The “Rich” Get Richer…

The values of apartment buildings fluctuate. At a very important level that’s because they can be thought of simply as machines that generate a stream of income (called the Net Operating Income, or NOI). The thing is, as interest rates change the market doesn’t pay the same lump sum for a given stream of income (see below).

The values of apartment buildings have been climbing for a very long time, and the growth / decline data has become ambiguous. Some data indicates softening values, some doesn’t. Even if values begin their cyclical decline it is nothing for owners to lose their composure over. The two most important reasons to own rental units are (a) cash flow and (b) equity build-up. The “paper” change in value should not affect either of those cardinal items.

Cash flow almost always starts well above Treasury note rates and, with proper management, adjusts for inflation. Fact is, cash flow usually grows faster than inflation. Just try to find a bond with that characteristic.

Equity build-up analysis is simple: As the tenants pay off the mortgage, the owner(s) will eventually have a free-and-clear building. When that happens cash flow (see above) shoots right up and those Manolo Blahniks become suddenly affordable.

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To review for newer readers, the computed value of almost any stream of income is the net income divided by the yield. In the case of apartments, the income is the Net Operating Income, or NOI. The yield is the market capitalization rate (in decimals). Just grab any old calculator and (a) plug in the net income, (b) press the “divide” button, and (c) enter the yield (remember, in decimals). Tap the “equals” sign and the market value of that stream of income will appear. If you do this a couple of times with slightly varying yields you’ll see how much the final value is affected by even a relatively small change in the cap rate.

For example, in 2000 the 10-year T-note yielded 6.7% and the market valued a hypothetical perpetual annual net income of $100,000 at just under $1,500,000 ($100,000 divided by .067). By 2008 the interest rate had dropped to 3.7% and that $100,000 became worth $2,700,000 (all numbers rounded).

Then the crash happened and the Fed responded by forcing rates even lower.  In early January, 2015, the yield on the 10-year Treasury note was 1.9% and that perpetual $100,000 stream of income became worth $5,000,000.  Over those 15 years the market value of that $100,000 stream of income had grown over 300%.

And that is how the rich get richer: they simply have marketable assets as capitalization rates trend downwards.  

. . . And Later, Poorer

But since the recent low the 10-Year note has risen to 2.4%. What was worth $5,000,000 in early January, 2015, is now worth $4,200,000 ($100,000 divided by .024). The investment has lost 16% from peak value. 

When rates return to their long term median – for the 10-year Treasury it’s 6.57% — that $100,000 stream of income we’ve been exploring will again be worth about $1,500,000.

The lesson here, as always, is that values go up when rates go down. This happens pretty much automatically.  Alternatively, when rates go up values go down. Again, it happens automatically.

But rising interest / cap rates are not a bad thing for everybody. Some forward looking people are going to make money on the drop in investment values.

Hypothetical Example: At the market peak, assume $500 would buy a nice 10 unit building at a 5% cap rate. The building would bring in $25 a year in net operating income ($500 x 0.05). But when interest / cap rates go up to (in this example) 10%, that same building will be worth only $250. ($25 divided by 0.10) Almost everybody who hears this little story identifies with the guy who bought at the peak of the market and quickly lost half of his investment. There is always somebody who buys at the peak.

And there’s always somebody who buys at the low. What about her? Consider the person who arranged to have a little cash in her unmentionables drawer, and when values bottomed bought two ten-unit buildings for $500.  We all understand that rates fluctuate over time, so when rates later return (in this example) to a 5% cap rate the person who bought at $500 will break even, but the one who bought when rates were high (and values low) will have done very well. Her money will have doubled.

Basically, management of an apartment portfolio (in its growth phase) requires refinancing currently owned buildings as rates decline. Lowering rates automatically develop equity. Then that equity is cashed out and used as the down payment for another building(s).  

When rates increase (and values decline) the apartment investor sits in front of the fireplace and plays with her rent checks. Who cares that her buildings have lost “paper” value? She’s comfortable in the knowledge that as long as rents do not decline her buildings are secure. So the strategic plan is: Rates up? Buy with both hands. Rates down? Take up plein air painting. 

The Market is Ambiguous

It’s pretty easy to speculate on how different rate scenarios impact values. It’s a lot harder to forecast exactly when changes might happen. But when it happens, we’ll know. It will hardly be a secret.

There is always a lot of data out there, but recently it’s become less encouraging. The recent data can be read many ways, but the two most likely forecasts are either a stable market or a bumpy one.

Stable Market: The California Public Employees’ Retirement System (Calpers) is a $300 billion fund holding about $25 billion in investment real estate. Bloomberg has recently reported that Calpers intends to sell about 12% of its non-residential holdings and reinvest the proceeds into other real estate assets. Non-residential? It’s reasonable to interpret this as Calpers believing commercial properties have peaked, but not apartments.

Stable Market: Hui-Yong Yu has reported that Blackstone Group has agreed to buy 25 buildings containing around 1,000 units in the Upper East Side of Manhattan for about $700 million dollars. That comes to right at $700,000 a unit, while the median apartment rent in Manhattan is $3,369. Putting those two figures together and adjusting for estimated New York City expenses, we get about a 3% cap rate at a price of 17 x gross.  

In our area that may seem a little pricy, but it would be a mistake to automatically think Blackstone is overpaying. The Group is a major real estate investor, and this is not their first batch of cookies. Remember all those single-family homes that were foreclosed between 2008 and 2010? Most of them were bulk sold to several large private equity concerns. Blackstone bought 48,000 rental houses. It is the country’s biggest rental SFR owner. There is a consistency here. Once again, just like in the CalPers case, we’re seeing experienced investors favor residential income.

Stable Market: The very useful Green Street Commercial Property Price Index has risen 5% year-to-date. Green Street Advisors is a well respected independent research and consulting firm concentrating in REITs and the commercial markets of North America and Europe. Most of their data is reserved for private clients, but the Commercial Property Price Index is publically available.

Assigning a value of 100.0 to 2007 peak values, the Index shows property values dropped about 39% by mid 2009, but have subsequently recovered to 18% above pre-crash levels. Measuring from the bottom of the market, that’s an annual growth rate approaching 14% compounded, which is probably not sustainable. The Green Street CPPI is important in that it reflects actual value changes over the recent past. At a gross level, it supports Calpers and Blackstone’s purchase decisions.

Bumpy: Some people have opined that South Florida is important to us because it’s a leading market indicator: what happens there will eventually happen to us here in urban California. It may not happen to the same degree, but likely in the same direction. So we watch Miami-Dade County for early signs of a changing market.

South Florida is notorious for property booms and busts and right now Crane Spotters shows a frightening projection.

The greater Miami area currently has 359 condominium towers containing 43,000 units. Notwithstanding the number of present units, there are currently 40,000 more units proposed (14,170 units), planned (14,787) or under construction (10,855). That’s a total of 39,812 units coming on line in the next 36 months or so. Condominiums compete directly with apartments. I’ll get your tea while both of us reflect on that for a moment.

From the beginning of time right up until now, while we’re waiting for the water to boil, the demography of South Florida evolved to support a total of 43,000 condominium units. Within the next couple of years there will be another 40,000 brand new homes coming on the market. Do not think that will double the listing inventory. It won’t.

Generally, condos tend to sell about every eight years or so. Some turn over faster, some take longer between listings, but there is a line-of-best-fit in the re-listing of South Florida condos and it seems to be about eight years.

So let’s put some rough numbers to it. If there are 43,000 existing condos and 1/8th (say, 5,000) are listed every year (most, but not all, are probably sold), then we know that the current demand for condos peaks at about 5,000 units.

And now 40,000 new condos are coming on the market over the next three years, say about 13,000 a year. Imagine a total of 18,000 condo listings and only 5,000 buyers. Some of the condos, about 28% of them, have been around a while and everyone who might be interested has their phone numbers. Suddenly, an additional 13,000 new girls are getting off the bus with their hair just done and fresh lipstick on and desperation in their eyes . . . and nobody expects the sailors to get picky? 

It is difficult to believe that the market will quickly absorb all those units. Prices (especially on the older models) are almost certain to suffer. It’ll be a fine time to be a buyer. 

Bumpy:  The Associated Press revealed that federal regulators will require the eight largest U.S. banks to add $200 billion to their capital base. The hope appears to be that capital surcharges will either (a) require the bank to fund their loans with more of their own capital and less borrowed money or (b) force the bank to shrink so their potential market failure will pose less of a threat to the financial system. Banks have been through this before. You know how we’ve talked about fractional banking and how a bank that (for example) is required to keep 10% of its assets as reserve against losses can lend out 90%? If the reserve requirements are changed and the bank has to keep 15% to cover potential losses, it means fewer loans can be made and interest rates will probably be higher. Rates going up? Well we know what that does to stream-of-income investments.

Bumpy: A Bloomberg article by Christine Idzelis and Craig Torres discusses

shadow lenders and what they’re doing. Shadow lenders are “asset managers that operate outside the banking industry’s regulatory oversight”.  

The Basel III international banking standards require banks to increase their reserves for commercial real estate loans. That makes the loans more costly and reduces their profit margin. See above. A shadow lender, as an unregulated institution, that can make loans with less overhead is a stressor to the banking industry. Remember Blackstone, the folks who are buying those 25 Manhattan apartment buildings? Another group under the same overall umbrella (Blackstone Mortgage Trust, Inc.) made a $600 million loan last year to finance two condominium towers in Hawaii totaling 482 units. Thus, due partially to lower regulatory overhead, non-bank lenders successfully compete with even the largest banks. And with unknown but possibly inadequate reserves, the failure of one or more major shadow lenders would be noticeably disruptive to the economy. Consider what happened in 2008 with Bear Stearns and AIG.

Bumpy: Another Bloomberg article, this one by Matt Scully, reports that Moody’s Investors Service for the second time in 2015 is cautioning of potential defaults in recently issued U.S. Commercial mortgage bonds. The issue is that appraisals are historical in nature (since they rely on comparable sales that have already happened). This means that in a declining market the (historical) comp sales will indicate a higher value than is (currently) warranted. How much higher? In mid-2007 the loan-to-value ratio on new commercial backed securities was 117.5 percent. That means that, due to the historical nature of comparable sales, large institutional properties were mortgaged above their full market value. Moody’s says the LTV is now 117.8 percent, a touch over the mid-2007 peak. This probably isn’t a good sign. 


The data are mixed. While there are a few observers that seem to think income properties will grow to the sky, they are wrong. The best hope is for a “stability” defined as small, but possibly frequent, fluctuations about the “new normal” cap rates.

There is, however, much data indicating that at least some markets are overbuilt, overpriced, and over-mortgaged. But a prudent investor can survive even a bad market. Naturally, the investor would have to have reasonable reserves for the inevitable surprises. And the individual’s portfolio should be supported by mortgages that feature long term fixed rates with low interest rate ceilings. Some folks refinance in uncertain times like these so they can get a longer fixed rate term and pull out enough to fund a proper reserve. In any event it is important to have a level of comfort that – assuming rents don’t change – the loan remains serviceable even as interest rates go up.

This article is for informational purposes only and is not intended as   professional advice. For specific circumstances, please contact an appropriately licensed professional. 

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected] 

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at