Two Disclaimers: 1. Before everyone comments there is more to underwriting than projecting exit cap rate and it varies by market, know that I already know that, and this post is regarding a general concept and a question posed get your thoughts. 2. I originally posted this a year ago and I am happy to share the results in a comment on this post, but before I sway anyone's opinion I would love to hear your thoughts...

So with that said, historically the industry accepted standard for underwriting a projected exit cap rate is the market stabilized cap rate plus a 10 bps for every year held. The reason for this is because there is a possibility for interest rates to expand and/or market conditions to soften. For example if you are buying a value-add property at a 4 cap, but the market stabilized cap is a 5, and you are holding for 5 years, you would expand the cap rate to a 5.5 exit cap. (I am not saying that is how everyone does it, but that is a general industry accepted standard). This industry standard has been adopted over the past several years, and during that same tenure cap rates have compressed mainly due to a decrease in interest rates. In other words, using that same example above, when people have recently exited they were able to exit at 4.75 or lower in some cases! I have continually preached (since 2018) that cap rate compression (and interest rates) is what landed the historic 20+IRR returns, not operations, which is why so many people have been, and are still, in hot water right now with being forced to perform via strong operations.

Today, we find ourselves in a much different situation. As interest rates continue to hold steady at an inflated rate, cap rates continue to as well. The question is whether or not the interest rates will continue to rise, stabilize or (dare I say) fall. I don't have a crystal ball so I don't know the answer, but I would suspect at some point over the next 3-5 years the interest rates will come down again. That period of time also just happens to be the industry standard hold period for a value-add. So the question I have for all of you, is if you believe the same to be true how do you underwrite the exit cap? I think we could all agree there are basically three answers:

A) Stay the course - keep adding 10 bps for each year held based on stabilized market cap rate

B) Take a little risk - use the current market stabilized cap as the exit cap too

C) Throw caution to the wind - use a cap rate that is less than the current market cap (*If you pick this answer what method are you using to predict a cap rate)

Which answer would you pick and why? Can't wait to hear your thoughts!!

Ashley Wilson

Podcast Guest on Show #277

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