Cap Rate Compression — Dinosaurs, and Squirrels – Part 2

Bruge, Belgium
Bruge, Belgium

The years leading up to the financial crisis saw global capital flooding the US markets with cheap capital for individual mortgages (which was used to over-build the wrong stuff).  At the same time, capital for building apartments was reduced.  Now we find ourselves in a market where shortages of skilled labor will prevent us form coming remotely close to delivering on the backlog of pent-up demand at the same time as we are seeing rapidly increasing new demand for rental housing.

Capital is available for building large scale apartment projects at unbelievably low Cap Rates these days because rents will be stable or continue increasing until the problem of low supply can be addressed in 20 or 30 years.  Capital for apartments will not be a problem for a very long time.  The fundamentals are that far out of whack.
The yield on the 10 year US treasury bond below 2% and Cap Rates on large multifamily deals have dropped to just over 3%.  That little tiny one point spread means that the people  who are managing money for insurance companies, investment banks, pension funds, etc. don’t see any serious risk in investing in apartments.
For those who want to explore the fundamentals in greater detail, I recommend reading Multifamily Executive from time to time. This trade magazine covering the business of  large scale apartments is available online for at no cost.
The steady trend of Cap Rate compression shows how institutional capital is crowding out small investors in the world of conventional sprawl garden/carport apartments and in large (and capital intensive ) apartment mid-rise and tower buildings.  This pressure makes the incremental building of modest apartment portfolios in walkable urbanism a solid opportunity for small investors, because they are being crowded out of the other stuff.

So, the good news is there will be no shortage of capital for building apartments in walkable urbanism.  The delivery of apartments in walkable urbanism will not be constrained by any lack of capital.

The bad news is that apartments in walkable urbanism will be constrained by a lack of capacity to deliver competently and to deliver these buildings at any meaningful scale.  This is why I think Lean Urbanism is so important.
These are the big forces that I see swirling around the US economy:
  • Under production of all apartments over the last 10 years, and along with that a shortfall of apartments in walkable urbanism.
  • A shortage of skilled construction labor for the next 10 years, even with significant immigration reform.
  • A significant increase in demand for apartments in walkable urbanism (Nelson).
In my experience, there is currently significantly more equity capital available than there are good deals to put that capital to work in.  The reason there are not a lot of good deals at the scale I think is critical to walkable urbanism, is that there are not enough small developer/builders producing them.  There are lots of big “dinosaur” developers and not enough small, locally focused developer/builders “squirrels”   https://rjohnthebad.wordpress.com/2015/03/08/dinosaurs-and-squirels/
I do not anticipate a land rush of financiers and developers looking for chances to do small apartment buildings in projects with less than 50 units in walkable urbanism or in distressed neighborhoods.  They are dinosaurs and need way more than 50 units to be able to operate. The most significant barrier to entry is to be able to operate at a small scale in a local context.  Existing outfits with business models that require lots of units cannot get that done.  They don’t have a reason to reinvent themselves as squirrels.

 

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