Why do I love the apartment business? On one hand, it seems so simple – maximize rent, minimize vacancy and other expenses, provide a respectable place for residents to call home and the investment will treat you right over the long haul.

On the other hand, it is a highly complex business involving hundreds or thousands (depending on your portfolio size) of prized residents who each bring their own distinct set of expectations, related monthly revenue fluctuations, expenses controlled only through attentive and strategic management, AND, investment market pressures such as interest rates, sales volumes and cap rates that significantly impact value but are virtually beyond our control. Unfortunately (or fortunately), I tend to see the business on this more complex “hand”. I am captivated by these complexities. And, I’m continually enthused about opportunities they present to create value. Some would say I’m sick, but I’ve survived this affliction for over 20 years, so apparently it’s not terminal.

I’ve been dialoguing with an investor who planned to sell an apartment asset in 2009. Those plans are on hold, but there’s still the question of future value. I did some research on cap rate trends in this region, and was able to plot cap rates as far back as 2002. Not surprisingly, the result shows a steady decline until 2007, then a sudden uptick. Suspecting a relationship with changes in sales volumes, I plotted those and identified the expected uptick in 2006, and steep decline towards the relatively low volume we’ve seen in the past six months. But I really wanted to see much more history, plus an interest rate relationship.

Unable to dig up the necessary data myself, I turned to Mike Scott of Dupre + Scott Apartment Advisors. Not only did he come through, but he posted the info for all subscribers to enjoy (click here for his Seattle area apartment observations report). It’s a fascinating graphic.

My observations are as follows:

• From 1980 to about 2000, cap rates generally fluctuated in the 8% – 9% range. Then, in 2001 they began an unprecedented decline towards 5% in 2007.

• It’s very interesting to me that the cap rate decline (apartment price increase) started in 2001. This was an unusual time. The overall economy was hot, and fears were circulating about sustaining growth. The Dow Jones Industrial Average hit 11,000 (click to see DJIA returns since 1970). We suffered the 9/11 tragedy. We experienced the beginning of the dot com bust.

• Sales volumes were down significantly in 2000 and 2001, so perhaps a classic supply-demand relationship can be a partial explanation of these changes.

• In 2000, the total returns for the apartment sector of the NARIET index hit 35.49, by far its highest level since 1994 (click to see NAREIT sector annual returns 1994 – 2008). Perhaps these returns fueled acquisition, driving prices beyond traditional boundaries.

• Interest rates for apartment investments were 300 basis points over cap rates in 1980. I was surprised to see such a long period of negative leverage across the market. That spread decreased to less than 50 basis points in 1987, expanded until 1992, then reversed to trend just below cap rates until about 2000. At that point, interest rates took a nose dive, and cap rates followed.

• The significant spike in sales volume occurred between 2004 and 2006. I would suggest that much of this is related to condo conversions. However, the trend was established, and if conversions were removed, a return to the pattern in the cycle can be easily extrapolated.

Again, this is a complex business. So what do these observations suggest about the future of apartment investments? I could argue a few differing conclusions. My sense is that low interest rates will be available at least until there is consensus that our economic struggles are behind us. Given the highly volatile nature of the stock market, and the renewed emphasis on transparency, it would seem that the physical, local, and verifiable characteristics of apartment investments will support strong pricing and therefore keep cap rates relatively low.

So what have I conveyed to the aforementioned investor/client? I suggested that we re-double our effort to increase Net Operating Income. This is what we at Thrive spend 90% of our time on (in fact, we’ll be blogging on that subject, so check back soon and often). After all, NOI is what we control, and is what drives value. As to the timing of sale, once we’re sure we’re maximizing NOI, timing becomes a function of the specific financing terms for that property, and the investors individual priorities. All things considered, I can’t conclude that the drop in cap rates between 2000 and 2004 will be mirrored by an increase in cap rates between 2009 and 2013. There simply isn’t a precedent for that in the past 29 years.

I am not an economist; just a guy with observations, opinions and questions, and a passion for creating great apartment investments. So what do you think? Comment here, I’m all ears.