A client recently retained us to help determine the feasibility of a project that won’t be ready for occupancy until 2027. While we have assisted hundreds of developers in determining the feasibility of future apartment buildings, these are typically one to three years out.

Projecting five years into the future, especially in a market like the one we are experiencing, was a daunting task.

Our first step was to think about four main factors that affect rent levels in a stable market environment: location, unit mix and size, building finishes and amenities, and the property management platform.

The subject property had all the right characteristics. It was in a prime location poised for future growth within walking distance of public transit hubs and many community amenities.

Our analysis of the area showed that target renters would be young professionals and the unit mix of mostly one-bedroom units and some larger units were appropriate for the renters the building would attract.

The building was expected to have top-quality amenities as well as A-class property management and leasing staff.

All of these factors made us confident that the property would achieve high rents for today’s market and that all of the factors were in place for top-of-the-market rents to be achieved five years from now.

Cap rates more difficult to predict

But as much as we say rents are one of the biggest drivers of value, cap rates are an even greater driver.

In order to project out the value of the building in five years, we needed to have a picture of cap rates that will be as accurate as possible for that time.

In our view, cap rates are driven by three factors. The first is investor IRR expectations.

Think about this: if bonds, a historically safe investment, are paying five per cent, there is not much incentive to invest in apartments, a seemingly riskier investment offering let’s say 4.5 per cent return. On the other hand, if bonds are only paying two per cent, then the apartment alternative seems worthy to pursue.

The second factor affecting cap rates is rent growth. If you believe rent is going to be strong in the future, then you’re prepared to pay a lower cap rate. Conversely, if rents in a location were currently high but you knew that a major industry there would be drying up in two years’ time, then rent growth would be weaker, and a higher cap rate would be expected.

What is the impact of inflation on apartment values?

Well let’s assume inflation is eight per cent and interest rates are five per cent. If you own your building for a year, is there a difference in value of your building at the end of that year?

It’s not going to be eight per cent more valuable (could it be three per cent more valuable?), but we think it could play a role in a higher value, just as inflation does in all kinds of other hard assets.

Interest rates and cap rates

The third factor is interest rates.

Generally, people expect that if interest rates go up, cap rates will go up, too. This may be true, but it is not an exact correlation.

Analysis done by Witten Advisors in Dallas suggests there is only a 0.62 correlation between interest rates and cap rates (i.e. when interest rates turn up, cap rate direction turns up in direction only – not in magnitude).

We have seen interest rates double to some extent and the expectation is the future is unknown.

We’ve put it all together into a formula and when it came to our client’s study, we were able to apply this formula and project out a cap rate .

Cap rates and interest rates do not move in lockstep at all. Canada is an attractive place to invest in an uncertain world and apartments are about the safest investment in the alternative asset class of real estate.

Inflation should be brought under control with higher interest rates, and even if it’s not, hard assets typically benefit from inflation.

Cap rates may go up more in other asset classes, but any increase in interest rates will be muted.

It’s difficult to predict the future of cap rates, but in Conrad Black’s epic book Rise to Greatness, he talks about the future of Canada and says “The past reveals the future.”

We think the same about cap rates!