Cap rate decompression?

Interesting that you would underwrite a 50-100bp compression on exit cap assumption. From my experience, that is an aggressive underwriting assumption and I know a lot of players that will underwrite a 25-75bp expansion in their exit cap. That said, it's simply a sensitivity exercise and I'm assuming that you wouldn't pursue deals that only penciled under the compressed cap rate assumption. 

To respond to your initial questions:

1. Yes, I think we can expect to see cap rates generally expand at some point, who knows when though. Rates are rising which means investors (who utilize leverage and care about cash flow) aren't able to pay as much for an asset, causing cap rates to rise slightly. This is an example of the general relationship between cap rates and interest rates. Also, I'm not sure I follow the last sentence in your first paragraph. All else equal, the asset's NOI would remain the same but the asset value would decrease due to a higher cap rate (e.g., $10k in NOI @ a 5% cap is $200k versus $167k @ a 6% cap).

2. "The best asset to buy" really depends on what your wheelhouse is. There will be opportunity in every asset class and it all depends on what you're familiar with / at least have an interest in. Also, not every asset class will see an expansion in cap rates to the same extent; this may open the door for more opportunity in certain niches. Which ones though? Who knows. All depends on market and economic conditions and where / who gets hurt the most, and what asset class that group impacts the most.

3. This is just my take on your last question - sure, stable cash flow is important and has its place, especially in an economic downturn. However, where the oppportunity really lies, is acquiring assets on discount (i.e., when cap rates are rising and people are scared). I find it to be a similar approach to the equity markets; are you going to focus on your stable, fixed-income investments during a recession or are you going to be seeking heavily discounted value buys? It's a question of overall risk tolerance and investment strategy, but you get my point nonetheless. 

Happy to hear any other takes on this.

Christophiish

If we are experiencing a cap rate compression in this market, can we assume that as the pendulum swings the other way, there will be a cap rate decompression? If so, I would assume it's the asset's value that becomes cheaper and not it's NOI.

Coming from a retail, value-add background, we always underwrote a 50-100bp compression on exit minimum. If there's a decompression then what would the best assets to buy be? Would PE funds follow REIT strategies with a focus on cash flow instead of exit value?

I think you need to sort out what you mean by compression and decompression.  Usually compression means lowering your cap rate.... which means that 100 bps of "compression" is a bet that the asset will get significantly more expensive.  It's almost impossible to believe that there is anyone out there who underwrites cap rate compression.  Perhaps you think decompression and compression are the same thing?  Because the term you'd usually use is expansion, not "decompression".

And the fact that you come from a value add background means nothing.  Cap rate compression is, by it's very nature, not a value add.  In fact, if you're adding value, then you'd expect to see cap rate expansion, because the next buyer can't increase NOI as much, since you've unlocked that revenue (or opex savings, whatever).

EDIT: Also worth noting that there is not really an effective difference on "cash flow" versus value.  Value is derived from cash flow.  

Yea honestly, underwriting a cap rate compression on exit in this market makes no sense. Obviously your doing it to artificially inflate your IRRs and appease your LPs, but its not going to happen. Curious to know if your LPs have questioned the logic there?

To answer the question of why we underwrote a lower cap rate on exit is because we bought retail in secondary and tertiary US markets that had low to mid 80 occupancy and have been able to sell at mid to high 90 occupancy, stabilized over a few years on exit. To be fair, it was a short stint and I worked there over covid so retail was in the dumpster and those markets were taking a huge hit with the idea floating that retail will never return to its previous state. However, with higher, stabilized occupancy our asset value increased exponentially and thus we underwrote a lower cap on exit.

But my point was that cap rate compression means all asset cap rates lower. Office might go from 3 to 2.5% while retail could go 10-8%. So my thought process was if there is a market swing and we see a cap expansion where the inverse happens, what’s an interesting investment thesis to overcome losing value on a property. Such as retail could be bad if it has the highest cap rate increase (8 back to 10) where as office is the lowest (2.5 to 3).

Unless I’ve missed something fundamental here which I’m always open ears to learn. I wanted to pitch the question to generate some thoughts.