Capitalization rates move higher or lower for a number of reasons. Supply and demand is one of them. More buyers chasing fewer deals will tend to bid up sale prices, lowering capitalization rates. That was clearly evident between 2005 and 2007.

Another reason capitalization rates move higher or lower is as a response to changes in the cost of capital. Since most apartment sales involve substantial financing, changes in mortgage rates have a significant impact on capitalization rates.

The capitalization rates and mortgage rates graph with this article shows the trend over the past 30 years. The capitalization rate is the average actual capitalization rate each quarter. The mortgage rate is the average interest rate buyers secured on their financing. It averages variable, fixed and seller-financing rates. We don't have data prior to 1980, but our recollection is that since getting into this industry in 1975, investors have been faced with “negative” financial leverage. That continued until the early 1990's.

Negative leverage

Negative financial leverage means your mortgage rate is higher than your capitalization rate, which negatively impacts cash flow. If you buy an investment that makes 5 percent, it doesn't make much sense to borrow money at 10 percent to buy it.

At the beginning of our career we read real estate text books that talked about positive financial leverage, or buying at capitalization rates higher than mortgage rates. But we didn't experience positive financial leverage for the first 10 years in the business.

So why were apartment investors willing to accept negative financial leverage then? We often hear people claim, “It's different this time,” but it usually isn't. People just want it to be different. They don't want the normal rules to apply because they don't like the outcome they'd produce. Well, it really was different then. Here's why.

Inflation

There are more reasons to buy apartments than just cash flow. First, the inflation rate averaged over 10 percent a year between 1980 and 1982. It averaged over 5 percent a year between 1988 and 1992. Inflation usually brings with it higher rents and sale prices. Rightly or wrongly, during inflationary periods investors anticipate higher than normal appreciation.

Tax shelter

Second, investors enjoyed tremendous tax benefits until 1986. The normal sales pitch to a prospective investor back then was, “you get your down payment back in three years from tax shelter alone.”

The tax benefits had a significant economic value, which helped offset the disconnect between capitalization rates and mortgage rates. Plus, the lure of tax savings brought a lot of new investors into the market who might not have understood the product or the market very well. If that was the first time this happened, it wouldn't be the last.

You can see from the graph that when those extreme tax breaks disappeared in 1986, investors tried to bring capitalization rates in line with interest rates. They managed to do that until the next inflationary cycle took hold of the market mentality again in 1988.

Finding balance

Both mortgage rates and capitalization rates trended lower slowly during most of the 1990s. In 1991, when investors were buying apartments at 9 percent capitalization rates, they were generally getting financing at 9 percent.

So, if your investment makes 9 percent and you borrow money at 9 percent to buy it, you also make 9 percent on your down payment in cash flow.

That's simplistic, since it excludes the “cost” of making a monthly principal payment, but it's a useful way to look at the relationship. It also ignores the risks and rewards of leverage at the time of sale. By 2000, investors were buying at 7.5 percent capitalization rates and getting financing at about the same rate. So they were making about 7.5 percent on their down payment.

Positive leverage

The relationship started to change early in this decade. As interest rates fell between 2001 and 2004, capitalization rates headed lower as well. But they didn't fall as fast. That was probably due, at least in part, to the impact of the recession. Vacancies were above normal, rents were lower and investors were cautious.

As recently as 2004, investors were buying deals with 6 percent capitalization rates and getting loans at 5 percent. That's called positive financial leverage and it's hard not to make money when you can get it. But as the graph shows, investors don't get it often.

Bullish buyers

Then, even though interest rates rose in 2005, capitalization rates kept falling. That was due to increased buying pressure. Investors were willing to outbid each other to the point where they bought deals that generated a yield near 4.5 percent while their debt cost them 6.5 percent.

You can't make money that way unless you are betting on significant increases in net operating income. They were, and it worked, at least for a while. Of course, you also have to be betting that the investor you sell to some day will accept equally low capitalization rates.

What's next?

Currently, capitalization rates are heading higher than mortgage rates once more. Investors are trying to compensate for the uncertain economy by building in some positive financial leverage once again. As the outlook for apartment performance becomes positive and investor demand picks up, cap rates could drop some. But it's clear from the long term trend that interest rates would have to head lower as well.

Even though interest rates are higher now than they were a couple of years ago, they are still quite low in historical terms. So the likelihood of rates falling very much over the next few years is remote. We admit it, we said much the same thing in 2000 when interest rates were 7.5 percent.

Or, the tax code could change to give investors significant benefits like they enjoyed in the early 1980's, but don't hold your breath. Or, inflation could kick in again which could lead to investors accepting cap rates lower than interest rates on the expectation of revenue and values rising faster. That could happen.

We believe inflationary pressure will build as the economy works its way out of the recession. However, look what happened before. Higher inflation should result in higher mortgage rates.

So even if buyers were to accept cap rates below mortgage rates in an inflation environment, mortgage rates would likely be higher than today. Even if cap rates didn't fall, they would end up lower than mortgage rates.

Patty Dupre and Mike Scott are with Dupre + Scott Apartment Advisors.