Exit Cap Rates in Models
Recently I was questioned as to why my exit cap assumption was flat to my going in cap. I thought it was conservative rather than showing cap rate compression, which I feel like is more the norm to get targeted returns.
Happy to apply something new here!
Yes, this is more conservative than underwriting cap rate compression on the exit. However, most firms like to see/have a 50bps expansion room on exit cap rate to ensure the deal is worth pursuing or viable. No true right answer
Thank you!
Flat is aggressive imo but it really depends
No it is absolutely fucking not
lol mad about that? Maybe multi is different (I am commercial only) but I wouldnt UW a flat exit cap ever, and we are as aggressive as it gets.
Flat 100% is aggressive at least in multi. Residual cap rates should always be above the entry cap. This is very basic fundamental stuff here that doesn’t warrant swearing.
I’ve always been taught expansion on the exit side. Multiple reasons, but the main one is that the velocity of raising rents is significantly lower once the asset has been stabilized/MTM, so investors would demand a higher return but anyone feel free to chime in if I’m incorrect.
Same but no one is going to get a deal done today with cap expansion... so let 'er rip!
Market, type of asset, going in cap rate, etc all dictate the optics here.
Not having any details, my broad brush take is cap rate expansion is the conservative approach and flat, by comparison, would be on the aggressive side. But again, it is all in what you can defend to your audience.
General assumption I’ve seen is around 10–15 bps of expansion per year or 50-75bps for the hold. It’s usually considered a "conservative approach", but like most rules of thumb, whether or not that is actually true really depends on the deal and market.
Cap rates move based on Required Return less NOI Growth. Since these are physical assets, a few things should naturally push the exit cap higher over time:
And then there’s the big one: capital flows, which are largely tied to interest rates. High base rates make equity less attractive, pushing cap rates up. If rates come down, equity gets more attractive and we might see some compression—but no one can really call that with confidence.
This is the most comprehensive and correct answer.
To restate the variables affecting exit cap rates:
Obsolescence risk
Credit risk
Execution risk
Macroeconomic risk
Thank you!! I really appreciate the thorough insight. This is what WSO RE is all about
I think you mean 5 to 10 bps of expansion per year, not 10 to 15 (and really closer to 5). A 10 year hold at 15 bps of expansion would result in an exit cap rate that is 150 basis points higher than the going in rate.
Historically, the majority of cap rate surveys (PwC, etc.) have shown exit cap rates around 50 bps higher than going in rates, on average. This is assuming a long term hold.
Last year, some surveys were actually showing lower exit cap rates than going in ("cap rate inversion") for certain property types/markets. Made sense when you had an inverted yield curve, but this has largely flattened out since then.
Fair pushback on the 5-10 & good reference to the PwC surveys which are an awesome resource. I think at the end of the day its really backsolving for ~50bps during the hold, so 10-15 would be a better range for a transitional value-add asset where the business plan is 3-5yrs whereas 5-10 makes more sense for a longer hold core/core+ asset.
Now, is that intentional to address an increasing level of credit/obsolescence risk for assets as they age and move up the risk spectrum? Or simply checking the box of a 50bps widening to make LPs feel comfy when they read the deck? Probably the latter... but something to think about
"(PwC, etc.) have shown exit cap rates around 50 bps higher than going in rates, on average. This is assuming a long term hold."
what?
Only thing I would add to this, is doing a next-buyer analysis to validate. Run an unlevered 10-year hold based on your exit cap. "Would you buy that deal" is my most common question to the folks that pencil whip exits.
It depends on your business plan.
when you buy a 12 kap no need to do irr analysis
And where would that be?
prob an hourly motel in topeka
People here will say to just use a flat per hour rate, but I like to break my hourly motel models up between oral, anal, vaginal, valet trash, etc.
Cracks me up when the holier-than-thou, tsk-tsk, gatekeepers preach about how they always model expanded exit cap rates .... at the same time they grow rents 10% per annum and expenses 3%. No wonder you're winning the deal with your 'conservative' exit caps. (Not directed at anyone here in particular .... it's all love)
hahah classic
100bps compression per year is my go to when I wanna show reeaaalll alpha.
Remember that all underwriting is just coming up with unrealistic assumptions that allow you to back into a purchase price that will win your principals the deal.
underrated comment but also highly accurate
I laughed at my desk lol so true
It just depends. If you are a value-add / opportunistic buyer it is totally normal to underwrite compression.
Imo stabilized yield is more important if it’s a value add deal. Tells you what your unlevered yield would be if for whatever reason you couldn’t sell or refi. Also gives you a sense of how much spread there is to capture vs stabilized cap rates (like a development spread you need enough compression to compensate for the value-add risk you’re taking)
Stress the exit cap all day long but the point of the exercise is to see if the deal only pencils in a cap rate flat or cap rate compress scenario. If returns are that skinny where you need everything to go right then the deal isn’t worth pursuing (at that price)
Look at this can of worms you opened. I’ve heard countless times the “industry standard” is 10bps of expansion for every year of hold. I’ve never actually seen anyone use that method but if you need to make up an answer and your numbers fit feel free to parrot it.
Here’s what I’ve seen in my experience:
Retail: 15-50 bps of expansion on Core+ in hot markets
Office: lol Godspeed. Who really knows (bought 5+ deals over the past few years, generally we UW 200-500 bps of compression but that was because we were buying previously Core assets and 8%-11% caps and you cant buy office rn if you think cap rates will expand more than they are.
Industrial: Flat to 25 bps for Core+ to light value add in hot markets. Key here is what rent growth you are UW. If you go agro on rent growth you shouldn’t be flat on the exit and vice versa
Multi: idk I’m not a dork
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