Quote from @Nik Batra:
I have been doing some due-diligence on apartment syndication deals. From what I have read and heard, a conservative underwriter should project the exit cap rate at least 50 to 200 bps higher than the purchase cap rate. I have however come across a few deals where the sponsor purchased the property at a much higher cap rate (around 7.3) than the market cap rate (around 6.4) and then projected the exit cap rate at around 6.8 (which is higher than the market cap rate but lower than the entry cap rate). Their strategy is mostly value-ad. Would you consider that conservative or aggressive when analyzing a deal from a passive investor standpoint?
Hope that question made some sense.
Nik
Nik, with all due respect to whoever gave you that advice, I disagree. Entry cap rate is absolutely meaningless. Participants in the commercial real estate space could do themselves a lot of favors by forgetting entirely the concept of purchase cap rate.
Cap rate has only one useful purpose--and that is to estimate the price in which the property may sell for at a later date. This has the obvious weakness of the unknown nature of future cap rates, but that's really the heart of your question here.
Estimating future cap rate is part art, part science. The science part is determining where market cap rates are today. Sale comps are a good start. The art part is adjusting today's market cap rate to a future year. There are a lot of opinions on how to do this--some say adding 50 to 200 bps to today's market cap rate, some say adding 0.1% per year, others say something else.
I suppose that's a good start, but doesn't really account for much. I'll give you a couple of examples. When the market was in the toilet after the great financial collapse, multifamily cap rates were in the 6-8% range. I was forecasting exit cap rates lower than current market cap rates. The theory: the market would be better when it was time to sell the asset. A better market meant lower cap rates. That bet came true.
Around 2020-2021 it was a seller's market and everything was getting a dozen or more offers. Cap rates had plummeted into the 4% range for multifamily. I was forecasting 5-year exit caps around 1% higher than current market cap rates (for perspective, that's a 25% decline in value). The theory: the market was about as good as it gets, and when it's time to sell, the market will probably be worse. Turns out the theory was right, but the decline has been even steeper.
You might be able to predict whether a future market will be better or worse than the current one, but predicting how much worse or better is nearly impossible.
And don't even get me started on how sponsors could be manipulating purchase cap rate, whether intentionally or unintentionally, by reporting pro-forma caps, non tax-adjusted NOI, and so on. If a sponsor is touting a 7.3 entry cap in a 6.4 cap market, I'd be digging really deep into how that 7.3 was calculated, and how that 6.4 was substantiated. This math implies that the property is being purchased at a 14% discount to current market value. Certainly not impossible, but the multifamily market (especially for larger properties) is pretty active and below-market purchases, while possible, don't happen as often as they might in the smaller property space.
Pro tip: If you still like the idea of purchase cap rate, use stabilized yield on cost instead. I defined that in the Hands-Off Investor. It's so much more meaningful than cap rate.
