Underwriting Assumptions Exceed Pre-Pandemic Levels for Prime Multifamily Assets

The average multifamily going-in cap rate increased by 38 basis points (bps) to 4.49% in Q4 2022, exceeding the pre-pandemic Q4 2019 average of 4.16%. Heightened market volatility and higher borrowing costs have pushed the cap rate up by 113 bps over the past nine months.

Markets where multifamily cap rates increased rapidly in the second half of 2022 in response to rising interest rates are expected to see no additional increases early this year. However, markets with more measured cap rate expansion last year are expected to see notable increases in Q1 2023.

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

Source: CBRE Research, Q4 2022.
Note: Survey was not conducted in Q1, Q2 and Q4 2020 and Q1, Q2 and Q3 2021 during the COVID-19 pandemic due to lack of trendable market activity and price discovery. Data in the above table is from the eight most recent surveys.

CBRE’s Q4 2022 Prime Multifamily Underwriting Survey found that investors are projecting 3.1% annual rent growth over the next three years, down from a 3.6% forecast in Q3 but equal to the level of the 2014 to 2019 period. Investors are slightly more optimistic about rent growth in gateway markets (3.25%) than non-gateways (2.97%).

Exit cap rates also increased to pre-pandemic levels, climbing 22 bps in Q4 to an average of 4.85%. Internal rate of return (IRR) targets rose 33 bps to 6.73%. Average asking rent was essentially flat during the quarter, rising just 1 cent to $4.46 per sq. ft.

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

Source: CBRE Research, Q4 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 top-tier relevant transactions are being completed. Estimates are based on the expert opinion of local CBRE investment professionals.

The Federal Reserve’s ongoing rate hikes to combat inflation have caused debt to become more expensive and less available, precipitating a rise in cap rates across all asset classes. For prime multifamily, the initial 39-bp cap rate spike in Q2 was the largest dating back to 2014. Since Q1, the average multifamily cap rate has increased by 113 bps. Additional cap rate expansion is likely as the Fed continues to raise rates. Going-in cap rates have surpassed the pre-pandemic level of 4.16% and currently are the highest since the survey began in 2014.

Figure 3: Historical Comparison of Going-In & Exit Cap Rates

Source: CBRE Research, Q4 2022.
Note: Survey was not conducted in Q1, Q2 and Q4 2020 and Q1, Q2 and Q3 2021 during the COVID-19 pandemic due to lack of trendable market activity and price discovery. Data in the above table is from the eight most recent surveys.

Exit cap rates have increased by 73 bps since Q1 2022 and the spread versus going-in rates fell to just 36 bps in Q4—the lowest since 2014 and well below the pre-pandemic level of 58 bps.

Figure 4: Change in Going-In Cap Rates by Market from Q1 to Q4 2022

Source: CBRE Research, Q4 2022.

Going-in cap rates increased last year in all 15 markets surveyed by CBRE, ranging from 188 bps in Phoenix to 50 bps in San Francisco. Although the Sun Belt markets had higher increases in average cap rates last year, they also had significant cap rate compression prior to last year and thus more room to move in response to rising interest rates. Many Sun Belt markets still have some of the lowest cap rates in the country. Meanwhile, uncertainty around the performance of Bay Area multifamily and other large coastal markets prevented their cap rates from declining as much over the past two years, leaving relatively less room for cap rates to expand as interest rates are now rising.

Multifamily investors are being more cautious in the current environment. While a bid/ask price gap exists for many assets, transactions continue to close. This reflects buyers’ long-term confidence and sellers’ willingness to lower pricing modestly considering many have significant embedded gains in assets purchased over the past several years.