Q. About Cap Rates and Compression/Expansion in Underwriting

[Jason Merchey]

I was thinking about the assumption that the cap rate will expand by 20 basis points in a 5 year period in a syndication I’m considering. From 4.5% at acquisition to 5.5% upon predicted exit. I was asking myself if it is standard and proper, anemic or robust. I brought this up with a colleague, and thought I would post my discussion to see what others think.

My understanding: Expanding the cap rate by 20 basis points (1/5th of one percent) per year as an assumption about the state of the market upon disposing of the apartment building in question is the syndicator basically saying: "We are not only not modeling in cap rate compression (which would make the property more valuable), we’re modeling in cap rate expansion, which means we’re assuming the market will decline during our hold. If we can sell an asset even though the market is declining, that’s very strong."

The crux is that based on their increased NOI, even at a 5.5% cap they are expecting to sell for $123m, which on a sub-100k purchase price is pretty good. Yes, they are ADDING value to the tune of $14m, but that still yields a healthy "return on cost" of all their renovations and operational improvements and such.

Anyway, so just as an example, let's say an operator bought at a 4.5% cap and the place had $1m in NOI year 1. That is a $22m sale price. Say they sell in year 5 and the NOI is STILL $1m (a miserable failure of management), at a 5.5% cap rate, that is an $18m sale price. That goes to show that such an operator is being conservative by modeling in a declining cap rate environment, because if they don't add value in one way or another, and therefore get that NOI up, and if the cap rate expands, they will LOSE money.

So bottom line, if in this case they can live with a 5.5% cap rate AND sell for a $25m profit in 4-5 years, that shows the power of the value add component and the ability to torque the NOI up way past where it currently is.

Response: Typically, appraisers will generally add 5-10 bps per year on the exit cap rate. This is to account for the aging of the property. So if on the hypothetical the first year NOI is $1.0mm and they buy it for $22mm the cap rate is 4.54%. If they hold the property for say, 5 years, using this rule of thumb, the exit cap is 4.54% + 25 basis points, so the exit cap would be 4.79%. So, your referencing of a 20 bps increase is reasonable. Assuming there is no value added and the NOI increases by 3% per year, the NOI in year 5 will be: $1,125,000 and the theoretical value will be $23.5mm ($1,125,000/.0479). So, yes, by doing the opposite of compression (expansion), they are being realistic and conservative.

Now, let's say this a value-added deal, and the first year NOI is $1.0mm. Let's say renovations and capital expenditures are completed by year 2 and the NOI increases by 6%, then Year 2 NOI is $1.06mm. If we assume that years 3-5 return to 3% annual increase, the NOI in year 5 will have grown to $1.158mm. Thus, the value is now $24.18mm... an "added value" of $681k.

On the actual deal in question, the operators are actually buying the property with a 20% vacancy factor. So, there will be two “value adds”: the upgrade of the units and the higher occupancy due to improved and professional management and marketing.

An investor takes a great risk in not assuming that cap rates will increase the longer the holding period. If they do this type of assumption they are saying that everything will proceed perfectly.

Second question: I am wondering if the purpose of the cap rate expansion assumption in proper underwriting is due to the aging of the building, or if it is just “adding some padding” to the conservatism of the underwriting in regard to the prevailing market values of typical properties in the same submarket. That is, a building shouldn’t really be aging in 4-6 years, all the while doing cap-ex and renovation, to the point that a 20% drop in the classification of the property is merited.

What do you think?