Investors Tighten Underwriting for Prime Multifamily Assets More Slowly in Q3

Going-in cap rates rose 33 basis points (bps) to 4.09% in Q3 2022, a slightly more modest increase than the 39-bps rise in Q2. Investors have reacted to heightened market volatility and higher borrowing costs by pushing cap rates up 72 bps over six months. However, cap rates have risen from record-low levels in Q1 2022 and are still slightly below the pre-pandemic (Q4 2019) level of 4.16%.

Figure 1: Historical Summary of Buyer Valuation Underwriting Survey for Prime Class A Multifamily Assets

Source: CBRE Research, Q3 2022.
Note: Survey was not conducted for six quarters (Q1 – Q2 2020, Q4 2020 – Q3 2021) throughout the COVID-19 pandemic due to lack of property sales amid price discovery. Data in the above table is from the nine most recent surveys.

Investors are underwriting 3.6% annual rent growth over the next three years, down from a 4.3% forecast in Q1 but more than the 3.1% average for the 2014 to 2019 period. Investors are more optimistic about rent growth in gateway markets. This represents a reversal of sentiment from six months ago when anticipated gateway market rent growth lagged behind the average for all other markets.

Exit cap rates also increased more slowly, climbing 21 bps in Q3 versus 30 bps in Q2. Still, the 4.63% exit cap rate remains well below pre-pandemic levels. Internal rate of return (IRR) targets rose 35 bps to 6.39%, surpassing the pre-pandemic average. Average asking rent barely budged during the quarter, rising by two cents to $4.45 per sq. ft.

Figure 2: Buyer Valuation Underwriting Survey for Prime Class A Multifamily Assets: Ranked by IRR Target & Cap Rate

Source: CBRE Research, Q3 2022.
Note: The statistics are estimates of current buyer underwriting assumptions for the highest quality asset in the best location of a particular market. The quoted prime rents reflect the level at which leases are being signed in top-tier buildings. Estimates are based on the expert opinion of local CBRE investment professionals.

The Federal Reserve’s ongoing efforts to combat inflation have caused debt to become more expensive and less available, precipitating a cap rate rise across all asset classes. For prime multifamily, the 39-bps cap rate spike in Q2 was the largest ever (dating back to 2014), but the increase was more modest in Q3. Additional cap rate expansion is likely as the Fed continues to raise rates. However, cap rates have not yet reached the pre-pandemic level (4.16%).

Figure 3: Historical Average Going-in Cap Rate for Prime Class A Multifamily Assets

Source: CBRE Research, Q3 2022.
Note: Survey was not conducted for six quarters (Q1 – Q2 2020, Q4 2020 – Q3 2021) throughout the COVID-19 pandemic due to lack of property sales amid price discovery.

Even with more conservative underwriting, Q2 investment volume in mid/high-rise multifamily assets (prime and other Class A properties) increased by 42% year-over-year. Mid/high-rise assets accounted for 34.6% of total U.S. multifamily investment volume over the four quarters ending in Q2 2022—in line with the historical average. Garden-style apartment buildings, which comprise the rest of the multifamily market, increased by 26.5% year-over-year during Q2.

Figure 4: Average Going-in Cap Rate for Prime Class A Multifamily Assets by Market in 2022

Source: CBRE Research, Q3 2022.

Going-in cap rates were flat in Dallas, Philadelphia and New York in Q3, but rose in all other markets. In general, pricing has held up better in gateway markets, where cap rates have risen 58 bps in six months, well below the 82-bps average for all other markets. However, the spread in cap rates for gateway markets versus all other markets (19 bps) is less than half of what it was (44 bps) in Q1, when pricing was at its peak.

Multifamily investors are being selective in their acquisition decisions in the current environment. While a bid/ask price gap exists for many assets, transactions are continuing to close. This reflects buyers’ long-term confidence and sellers’ willingness to lower pricing modestly in light of the significant embedded gains in assets purchased over the past several years.