At the depths of the Great Recession in 2008 and 2009, it was nearly impossible to determine what the right valuation metric was to value apartment investments. Fear was pervasive, people didn’t know if Net Operating Incomes (NOIs) were going to fall off a cliff, lenders were very conservative, and there was a perception that the market would be flooded with properties being sold by distressed sellers. In addition, the valuation of publicly-traded REITs and their preferreds were at extraordinary yields. These are just the environments I find invigorating and challenging.To quote an Oasis song, 'these are crazy days but they make me shine.'Click To Tweet
With fear being so pervasive my natural instinct was to determine if it was time to be greedy. I knew that single-family housing was not going to lead us out of the recession because it’s what got us into it and there was no way the government would support it as it had in the past. The contraction in credit was not only going to dramatically reduce the supply of new single-family homes but it would have a very large impact on apartments as well.
Eventually, when the economy did recover, new households would form, and nearly all of those would have to rent because of the much tighter lending standards among home lenders. In addition, renting provides tremendous flexibility to allow people to go to where the jobs are because they are not tied down to an illiquid, high transaction cost asset like a single-family home. Finally, after dabbling in the high yield investment market in 1990 and 2002, I knew that the extraordinary spreads being offered in lower-rated debt was a once-in-a-lifetime investment opportunity that would be very fleeting. The cost of capital would not remain that high for too long, apartments would be the first asset class to recover, and the continued lending (prudent) by Fannie Mae and Freddie Mac in the apartment sector would help stabilize values. So what was the right value?
I turned to the 1930s (yet again) for some guidance. I looked for any kind of information that would give me some guidance in terms of what were cap rates at the bottom of the Great Depression in the 1930s. After searching high and low I found the mother lode with this article in the New York Times from July 1, 1938:
What is so great about this article is that it covers four years, there is no dispute regarding the NOI, only the cap rates to be used. Naturally, the owner wanted a higher cap rate (lower valuation) and the taxing authority wanted a lower one (higher valuation). Regardless, however, the range was a low of 5% for the taxing authority and 6% for the owner. Pretty much the same cap rates that we felt properties should be trading for in a more normal environment, especially given that we thought we would be in a low-interest environment for a while. There was some fairly strong evidence that during the worst economic period in the 20th century and with unemployment approaching 25% and widespread vacancies in commercial real estate and apartments, cap rates were in the 5% to 6% range.