Cap Rate Compression

[Alberto M.]

I'm sure everybody here knows what a cap rate is, if you don't, a cap rate is basically a measure to understand your rate of return based on NOI (net operating income) the property is intended to generate.

In general terms, it is a simple formula:

Cap rate = NOI / Purchase Price

So far so good, however, it starts to get tricky when we talk about cap rate compressions. This happens mostly when the value of a house increases (due to let's say market factors) and the NOI stays the same, decreasing the cap rate (compressing).

Until this point I understand it perfectly and I hope was able to explain it clearly to those that didn’t know about it. My questions comes on how to determine a cap rate compression in a proforma for a project you are planning to acquire?

A couple weeks ago I received an Offering Memorandum for an investment opportunity and it had a proforma for 5 years. In the cash flows I saw that on year five they will intent to sell the property with a cap rate compression.

How can you know if that assumption is conservative or aggressive? How can you project a cap compression in 5 years from now?

I hope this helps as well as if someone can help me understanding this I would really appreciate it.

[Charles Seaman]

@Alberto M. Unfortunately, there really is no exact science to accurately predicting a future cap rate because none of us have a crystal ball.  Most groups typically underwrite deals with the assumption that cap rates will be higher when they sell a property than when they buy it (and that's probably a very good idea in the current time).  On the low side, I've heard of groups using a terminal cap rate that's 0.5% higher than the acquisition cap rate.  On the high side, I've heard 1.5% higher than the acquisition cap rate.  While it's great to be very conservative and use a terminal cap rate that's 1.5% higher than the acquisition cap rate, it'll also likely make you unable to be competitive on most deals.

The best suggestion that I can offer you is to really know the area that you're looking to invest in and to study historic cap rates.  Look at what cap rates were when times were good and when times were bad and also assess where that particular area was when those conditions applied in comparison to where it is now.  Past performance is no indicator of future results, but it is the best resource that we have available to us (unless somebody has a crystal ball).

Lastly, the other reason that cap rates will likely stay compressed, even in a down market, is due to the increase of dollars in the money supply.  As long as the government keeps the printing presses on, then people will have more dollars to throw at investments.