Cap Rates: why should exit cap rate be higher then going-in cap rate when using discounted cash flow analysis?
Explain why it is prudent to utilize a higher "exit" cap rate than your "going-in"/acquisition cap rate when underwriting the acquisition of a property using discounted cash flow analysis? I understand that having a higher exit cap rate accounts for growth in NOI for the property since NOI from year 1 should be smaller than NOI from end of year before the next buyer's year.
Here’s a good thread on it - https://www.wallstreetoasis.com/forum/real-estate/explain-to-me-like-im…
Your understanding of growth in NOI only impacts cap rate relative to what you paid for the property, not what it sells for. Your exit cap rate is relative to what an investor will be willing to pay for it.
The other thread that was linked is great, but to give some high level explanation here I'll say a few things, and remember that ignoring NOI growth a higher cap rate = lower price at the same NOI...
1. Buildings age and depreciate - people will be less willing to pay the same cap rate for a building that is now 10 years older (not a hard and fast rule and obviously dependent on market conditions, but just generally speaking all else the same).
2. Market conditions are likely to change over the hold period.
3. Taking the above two points into account, when you underwrite a property you are making your best guess at what is going to happen to the property through your strategy and to the market over the course of the hold period. You don't have to underwrite a higher exit cap rate. Maybe you have really strong conviction in the market and any potential policy/economic changes over your hold period, or maybe the building has been horribly mismanaged and you're buying it at a discount to market cap rates so through efficient management you'll be able to sell it at the same or lower due to the improved state of the asset. In these scenarios you might get more aggressive on exit cap.
#3 in mind, it's still considered prudent to revert at a higher cap rate because all else the same, a proforma is an educated guess. If the deal works at a higher cap rate, you're more likely to under promise and over deliver by using that metric which for your career is better. Further to that, unless you have really strong conviction its better to be on the conservative side with your numbers.
As a final note, I've been at shops where their bread and butter was to underwrite the same exit cap as going-in and they have done amazing for decades. This is because their bread and butter was buying underperforming, mismanaged assets and bringing institutional quality management to the table to improve their performance.
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