Reasoning behind reversion cap rates?

Question

Hi all,

Does anybody have a reason why we use a higher reversion cap rate in our analyses besides for the sake of being conservative?

I've heard that one should add 10 basis points per year to the purchase cap rate to derive a reversion cap rate. Is this just a rule of thumb, or is there an explanation (in a micro- or macroeconomic sense) for this calculation?

If anybody has a reason beyond "better safe than sorry" or "I like to be conservative," please share!

Thanks so much!

Brian Burke · Answer

Cap Rate is nothing more than a yardstick to measure the current market sentiment.  The lower the cap rate, the more value buyers are placing on a given income stream.  Real estate is a very sought-after investment class right now, and as such the supply/demand picture compresses cap rates to reflect how desirable it is.

The question is, is this as good as it gets?  Will real estate always remain this desirable, or will the supply/demand picture shift?  Will interest rates increase, which in turn devalues the same raw dollars of NOI because of increased debt service costs?

Cautious buyers forecast their exits with a decompressing exit cap rate because they believe that things are really good right now and to expect it will always be this good is dangerous thinking.

For example, let's assume that like-kind assets in a specific market are trading at a 5% cap rate.  If you are satisfied with the, IRR, CoC and multiple for your hold period with a 6% exit cap, and cap rates rise to 6%, you'll hit your targets and you'll be satisfied.  If cap rates rise to 6.5% you won't do as well, but you won't lose your shirt.  On the other hand, if cap rates remain stable and you sell at a 5 cap, you'll be ecstatic because you'll blow through your projections and post all over BP what a great deal you just did and why you are the best investor that ever lived.

Now let's say that you underwrite to a 5% exit cap and you are satisfied with the forecasted performance.  If cap rates remain stable you'll hit your targets and you'll be satisfied.  If cap rates rise to 6% you'll take a beating.  If they rise to 6.5% you could take a serious beating.  Then you'll close your BP account and go into hiding, not wanting to admit your failures and will forever curse real estate investing as just an alternative to gambling.

So people underwrite to decompressed exit caps because they want to be the guy in the first example.  No one wants to be the second guy.  But there are plenty of them....

Serge S. · Answer

Reversion or exit cap rate is simply the implied cap rate your end buyer will demand at sometime in the future. Hence the problem, we don't know what prevailing cap rates will be in year 3-10 as cap rates are based on a number of factors, interest rate being predominant. The higher the cap rate that buyers demand at exit, the less your sales price will be. As such you want a healthy spread in your underwriting. I like to look at the historical submarket cap rate over the last 20-30 years and compare to the current spread. I'll add 50 basis points to that. So in a market thats trading today at 4.5 cap but historically a 6 cap market, I will underwrite to a exit 6.5 cap. Brokers tell me I'm crazy and that 4.5% is the "new normal."  Sure would make it easier to buy an overvalued property if I was naive enough to listen.

Ben Leybovich · Answer

A: A cap rate is not a measure of return. Rather it's an indicator of market sentiment and more specifically investor's perception of the risk/reward. The more risk there is, the more projected return buyers demand, which means that for the same NOI buyers demand lower pricing and thus higher cap rates. Thus, a low cap rate is indicative of lower perceived risk, for one reason or another.

B: There is a relationship between the interest rates and the cap rates. If you were to pay a cap rate lower than the interest rate, you'd be losing money. So, in a rational market it is assumed that the cap rates will need to be somewhat higher than the interest rates.

Put A and B together, and since we've seen a run-up in interest rates, we would need to assume the cap rates going up, which we have not seen, meaning that the market is very bullish. So, the questions are:

1. Why haven't cap rates gone up with the interest rate? What's the market bullish on?

2. How long will this last?

3. What happens after the party is over?

The answer to 1 is that the market is a lot more efficient and smart than we want to sometimes believe. Some very big money is dictating the current reality, and they are deploying like nuts. Why? Well, in Phoenix, where I buy, for example, things look like this:

1. 1.5+ % population growth in 2018 (that's in one year)

2. Average apartment rent of $1070 to national $1470 (25% delta to the downside, in one of the highest growth environments in the nation)

3. Rent growth of 8.2% (There is a shortage of product. Why? Because you simply can't afford to build product to rent for $1000/month)

In a rational and well-educated environment, investors are willing to deploy at 5% cap for such fundamentals. Are they right? Are they wrong?

Who knows, but they are voting with their wallets, and they are deploying billions - I'd think they know something.

How long will this last? That's the million dollar question, but it shouldn't matter, because:

A. You should assume that it won't last, and inflate the cap rate to match the historical averages. (although we may not get there for quite a while)

B. You should underwrite the possibility of holding for a decade.

C. You should always buy value-add, whereby post-stabilization you can pencil significantly outperforming the market, whether it's at 5 cap, or at 6 cap.

Todd Dexheimer · Answer

I am in the historic cap rate camp, with an understanding of how the market has changed. For instance a Seattle, WA or Austin, TX had cap rates of 8% at one point, but the cities have drastically changed and therefor the historical cap rates have drastically changed. In this instance, I would be looking back at a much shorter time frame to project my reversion rate.

I also believe in being more conservative than less conservative. using the +10 basis point per year is not conservative enough in most markets. I am usually using 20-30 basis points per year in my modeling, as I feel we are very inflated in our pricing.

Serge S. · Answer

This data is readily available and usually provided by larger brokers. They email clients quarterly sumarket reports with detail.

Lane Kawaoka · Answer

Investment analysis often revolves around understanding exit cap rates, or terminal cap rates, as a major lens through which we evaluate deals. By conservatively assuming a future sale in a weaker market, say with a terminal cap rate of 6 to 6.5%, investors can stress test the resilience of their deals.

Take, for instance, a typical 5-year investment horizon. Here, the projected returns based on equity multiples are vital. At a terminal cap rate of 5%, and assuming all goes according to plan, your $100,000 investment might double. If the cap rate shifts to 6%, your return drops slightly but remains robust.

It's essential to monitor these rates closely, especially given the current high-cap period with potential for recovery. A few years down the line, we might see cap rates decrease to around 5%, significantly enhancing potential returns. This analysis is demonstrated in our chart, providing a clear visual of how even minor fluctuations in cap rates can impact your investment outcome dramatically.

Peter Tverdov · Answer

@Serge S. How are you able to get data on what cap rates have been in sub markets the last 30 years? That seems like incredibly valuable data.

Mike Dymski · Answer

Many of us regularly see aggressively modeled exit caps...and the +10 basis points per year rule of thumb is arbitrary.  I follow a similar approach to @Serge S. using historic norms.  It's more art than science...but more science an arbitrary amount.  I also find some offerings with more conservative exit assumptions (+15-20 basis points per year, mostly outside of MF).

Jon Schwartz · Answer

@Serge S., I like your thinking!

Where do you find the 20-to-30-year historical cap rate for a sub market? Thanks!

Chase McArthur · Answer

@Jonathan Schwartz

It is assumed that the NOI will increase relative to the purchase price of the property, therefore increasing the terminal cap rate.

For example:

100k NOI @10% cap = 1M value

A 3% increase over 10 years =134,392 NOI

134,392 NOI on 1M value = 13.4% Cap

Commercial property doesn't appreciate like residential properties. Valuation fluctuates based off of various macro/micro factors. There are variables that can have terminal rates lower than initial rates, supply and demand as well as interest rates are a few. But obviously we can't predict that a year from now, let alone 10 years.

All we really know is the starting NOI and the level at which we can increase it annually. You can see in the above example how the growth rate correlates with the terminal cap rate. A 3% annual growth equals approx a 300bps increase in the cap rate over the horizon, not a coincidence.

Reasoning behind reversion cap rates?

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