How does one determine/forecast cap rate? Say an interviewer ask you a question where you enter at 4% cap rate, how do you determine at what cap rate do you exit in 5 years? I guess the standard answer is to look at comps in 5 years, but if I had to come up with a number today, what should it be?
I was thinking along the lines of exiting at the same cap rate (assuming it's a stabilized asset), then your returns will be driven by your NOI growth. Or what other answers could I give?
Will it have anything to do with depreciation?
Many thanks.
Look at the historical trend in cap rates for the area. Use the median trend as an annual adjustment in your model.
I disagree. Median trends don't predict monetary policy or a multitude of other factors that influence cap rates. It's far better to just be conservative and assume a higher exit cap than entry cap while still making the deal pencil
Also, cap rates are a reflection of risk. So one can "predict" exit cap by determining how much risk they are either putting on or taking off the table at the end of the deal's life
I mean, you kind of touch it with a needle on the last bit. "While making the deal pencil" is license to assume anything you want. Which means it helps not at all
Entering at a 4 cap is already very low so doubtful you'd be able to assume any sort of cap rate compression, and you should probably rely on NOI growth. If you are doing a value-add analysis sometimes you can add 50 bps to your entry to be conservative and show the changes actually added value. The increased NOI should be big enough to make a worthwhile deal even if cap rates grow a bit.
I'd say a 50-75 bps spread between the OAR and exit cap would be more common than others for stabilized assets. However it is all relative to the asset. The riskier the asset, the larger of a spread you want. Vice versa for very low-risk assets, such as prime industrial or grocery-anchored retail assets.
How would you arrive at this 50-75 bps?
Hah, if only I can count the number of times debates in the office are spurred by this topic. You can't forecast cap rates, same way no one knows whether the stock market is going to go up/down/or sideway. Standard industry practice entry-exit spread is 50bps. Don't ask me where that comes from. Now this is where the "art" part of acquisitions/underwriting comes in. There are deals in hot markets like Austin where we'll drop the exit cap spread to 25bp-30bps in order to win the bid. No one knows what happens in 10 years. Theoretically speaking, the higher exit cap rate spread is meant to account for the fact that the property is aging more so than anything else.
That being said, I was on my ULI council and have heard that during covid, folks have been dropping exit cap to 25 bps or even keeping it flat to close deals. This is to account for drop in Y1 NOIs due to the pandemic and the fact that risk free rate has dropped substantially. There's no movement yet on entry/direct cap rates but people are dropping the exit caps to close deals now.
Agree with everything you've said.
50bps for a 5-year hold, and closer to 75-100bps for a 10-year. and basically adjust it down by 5-10bps to get the right IRR/EM at the deal level.
Cap rates have some correlation with interest rates, however. So the correct way to underwrite is to use a coefficent that bridges the 10-year rate with cap rate. If we are assuming rates will go up in 10-years so will cap rates. All I want to know is who is underwrwiting cap rate conpression?
Great point. I don't think any investors with fiduciary responsibility can justify have a lower exit cap than entry, but at the rate we're going, who knows?!
The relationship between cap rates and interest seems to break down at very low levels of interest rates. There just is only so low cap rates get on even in markets with negative interest rates (like in parts of Europe). So even if you expect interest rates to fall below where they are today, I wouldn’t expect cap rates to fall nearly as much.
Honestly, this is one of the most high quality in depth discussions of cap rates I have seen on this board, props to you.
If it’s a core deal, expand your cap rate 10 bps per year. If it’s a value add deal, look at today’s market cap rate. Use this as your start point. Expand you cap rate 10 bps per year.
for example, if you buy at 4% cap rate and the market cap rate is 5%, assume you will sell the asset at 5.5% in 5 years and 6% in 10 years.
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