Best Ways to Hedge Cap Rate Risk?
I'm with a firm that specializes in short-term opportunistic and value add investments. Basically flipping commercial properties.
With interest rates set to rise this year, we may see cap rates starting to rise as well. We normally don't worry too much about moves in cap rates as we buy deep value and aim to be in and out of our investments quickly, but I'm interested in getting other perspectives.
What do you guys do to protect against the risk of higher exit caps?
Unless you're doing a complete overhaul of a commercial property, it's really dangerous to underwrite cap rate compression over your hold period so on every deal you should be expecting to sell it at a wider cap than you entered. That said, the formula is pretty simple - if the exit cap moves higher you've got to incrementally increases cash flow. On value-add deals that's the whole ballgame anyway.
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There was a long debate about this topic (the relationship between interest rates and cap rates) on WSO a few years ago. I was--and am--on the side of believing interest rates and cap rates move together--but over the long run, not in direct, short-term relationship. There isn't a direct correlation (that I've seen in the data) between short-term cap rate and interest rate movements. What you see is a general, long-term move of cap rates with interest rates. So, cap rates have fallen the last 10 years along with historically low interest rates, but it wasn't over night and it's also market- and property-specific.
So, if I'm working on a short-term deal (1 year), I would underwrite the deal using approximately today's cap rates (although, everyone always should be conservative when underwriting, so hopefully you've got some bump there) and not worry too much about cap rate movements relative to interest rates.
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