Going in vs Exit Cap Rates for Stabilized & Value Add Deals
Hey guys,
I want to make sure I have this understanding down in terms of going in cap rates and exit cap rates when given a set of future cash flows or building out a DCF.
On value add deals I've noticed based on a normal assumptions in these cases the going in cap rate is lower than the exit cap rate (say 4% vs 6%). This is because of lease up the exit cap rate is valued on a drastically increased NOI.
And on a stabilized property you usually want to make sure your going in cap rate is higher than your exit cap rate to show you've increased rents and thus increased overall property value.
Basically:
Value Add: Going in cap lower than exit, fine because based on different NOI and overall increasing value
Stabilized: Going in cap higher than exit, want to show value creation even if property levels stay the same. Maybe pushing rents increasing overall property value over time.
This thinking correct?
nope. exit cap on stabilized asset should be higher than going in. Your property will be out positioned and will require greater CAPEX the longer you hold it. Typical cap rate expansion is ~50 bps over hold period. Even for development pro formas, institutionals typically underwrite a spot rate (i.e. going in) and then will expand the exit cap by ~5 bps/year.
This is more or less your answer, except for the part where we actually know what the cap rate expansion is. I'd say that most people will underwrite to a 50-75bp expansion over a 10 year hold, but that's more or less pulled out of thin air. Especially with current cap rates / treasury rates. I don't think most people actually have a foggy clue where assets will be trading in a decade.
The simple answer is that all things being equal, if your building is 10 years older, it stands to reason that it would be worth less (or less per dollar of NOI, more accurately speaking).
Got it, I'm just making sure I understand the thought process behind it. I have an Argus Excel cash flow test with two hour time limit end of next week where I have to come to a valuation and I'm assuming they'll either give me assumptions or I'll have to come up with my own.
All the doubters will tell you exit cap higher than going in (regardless of whether it's stabilized or value add), but the real winners here know in reality the exit cap rate will be lower.
And this, ladies and gentlemen, is how you win deals ;)
If you buy value add your going in will be high or even n/a, and your exit is low.
If you buy stabilized, going in will be low and exit is high because your asset is less valuable now
Your value add assumption of lower to higher cap rate is only based on lease up risk, not all value add types of risk. You could see contraction instead of expansion in other circumstances: term (WALT is short going in, long going out) and repositioning are top of mind, credit enhancement is another. Still underwrite expansion to the market cap, but the exit can still be lower than going in.
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