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.