How are you guys underwriting exit caps for assets that are trading 50-100bps higher today than ~2 years ago. For example, I am underwriting a single story MOB at 6.50% when last year comps were around 5.50%-6%. I would get crushed if I assume a 5.50% exit on the basis rates are going to "normalize". The deal still yields an acceptable LIRR at a 6.50% but idk I feel completely lost right now. Rather be conservative than get a deal approved on a poor/aggressive exit assumption. Am I being stupid here or what?
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When you say you'd get crushed do you mean your superiors would be pissed if you underwrote a 5.50% at exit? There's literature out there that discusses what happens to treasuries and credit spreads after peaks during rate hike cycles or other recessionary periods - they always normalize. It always feels aggressive to underwrite a tighter cap at exit than at acquisition, but this feels like one of those times you could do it. That being said, what I'd probably do is UW the same going in and exit caps, and then sensitize for tighter exits, and support it with the literature/data. At the end of the day you want your deal to make sense from a cash flow perspective and not just capital appreciation.
Side note, a 6.5% LIRR on an MOB deal is acceptable, and that's with assuming no exit cap compression? Is this thing like NNN leased to a billionaire doctor for 15 years?
Crushed meaning exactly how you defined it above. Lower exit cap, than stabilized. I put a few exit cap sensitivities together and showed the future upside if rates "normalized". I hear you on the cash flow part. We typically model 4 year holds with a sale at stabilization so little interim income to judge. We never look at 10 year cash flows...
And apologies, the LIRR is ~15% - I meant acceptable LIRR on a 6.5% exit!
If you're modeling a 4 year hold I would ream you out for modeling 100bps of cap rate compression in that window if I was your boss. That's just reckless underwriting. In 4 years you could say 25bps, maybe 50 if you're adding real value to the deal, but beyond that is insanity.
Hell I don't think 100bps compression is a reasonable assumption period.
Trust me.. i agree. I think modeling anything beyond 25bps is egregious but keeping the exit flat is safe.
Playing devil's advocate a bit here, but not underwriting compression just because no one ever has is lazy.
The 5 year treasury forward curve has rates stabilizing at 3.40% which is 60 bps inside of where it is today ~4.00%. Why would an investor's risk premium remain 60 bps wide when other capital will compressing spreads over the treasury? Over the last cycle, when we had a "normal" yield curve, and rates were near 0, it made sense to always underwrite cap rate expansion, because rates can only go up (i guess technically not if you are the ECB). Not only that, but forward curves historically have a tendency to be conservative. You shouldn't not do something just because it hasn't been the status quo for eleven years - and again, there's plenty of literature to support the idea that spreads will meaningfully come in. I'm not saying it's going to happen, but I'm just providing a fresh perspective :)
Right cause the forward curve has NEVER been wrong (hint - it's almost always wrong by a material margin, and being conservative from a historical perspective is looking at it as a whole and not during downturns as a standalone which is more relevant today).
I'm not saying don't underwrite any compression, but 100bps is fucking insanity and a violation of any quality firm's risk parameters. You're asking to get screwed.
Because everyone's risk premium today already incorporates the fact that the yield curve is going down in the future. Everyone is looking at the same curves to come to their conclusion on where they need to get their deal's yield to in the next 3-4 years to make sense and using that to back into what cap rate they can pay today.
Also as noted above, those things have never been right (go look at the curve you used in a model 2 years ago), so you don't want your deals returns to hinge on betting that yields/cap rates are coming down.
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