Interested to hear some thoughts; how do you look at a purchase cap when first screening a deal, and then what factors do you focus on as your process moves forward that make or break executing or bidding on it?
Tax adjusted T12 cap, yr 1 cap rate on purchase price, etc ...
Then how do you treat your exit? I’ve seen people assume nothing less than a 6.5, and I’ve seen exiting at entry cap, as well as cap compression...
Thoughts?
I thought the rule of thumb was to try and exit at a lower cap than what you purchased at - kind of what's suggested here - https://www.wallstreetoasis.com/forums/exit-cap-rate
Of course this is the goal, but if you take that to investors or committee they'll think you're naive, especially with the rate environment. that has at least been my experience
Additionally, even if you are doing a value-add deal, if the area has a lot of new development, there is a good probability that the exit cap could be higher. For example, even if you are renovating units, at the end of the day, the building is still 50 years old, and can't compete with brand new developments.
Therefore, it is scary when you bifurcate the IRR from these deals that have a 5 to 10 year hold or so, and find out that 97% of it is generated from the reversion.
Agreed. Something I'm becoming more aware of is the perspective many RE people have is siloed. Not all, but many. For example, big name brokerages continue to push cap rates as this big selling point relative to an asset class, but dont seem to consider that cap rates on core properties in better markets are trading at similar rates. There's no consideration of risk-adjustment. Or maybe they know exactly what they're doing and dont give a shit, bc some how people still buy. Consideration to other financial asset classes is given even less consideration.
+100 on this! I couldn't have said it better myself.
Unfortunately, I find that a significant majority of people in this industry live in a bubble, and have no exposure or volition to gain an understanding of other asset classes. For example, while I wouldn't expect an equity research analyst to know all the intricacies of the fixed income market, at least he/she would have a basic fundamental understanding of the investment drivers. If our industry adopted this approach, the valuation process would greatly be improved.
Making things too complicated re--purchase cap. The purchase cap is technically just the in place NOI/whatever number the seller tells you will get the deal done.
Exit cap...everyone is different. A lot of shops like to assume cap rate expansion of XX bps per year to hedge against rate expansion that dilutes returns. I've been at shops that said 5 bps per year, others 10.
Also depends on what kind of shop you are screening deals at. If a buy and hold developer or family office, they probably don't care much about cap rates and are likely more focused on yield since they never plan to sell. A merchant builder that will flip at C of O will care much more about it.
It’s completely dependent on the deal. Certain deals have nuances, such as when taxes are reassessed due to sale, that cause entry cap to be wonky in year 1 or 2. On the exit, it also depends. Some shops will expand cap rates 50 bps for a 5 year deal and 100 for a 10 year deal. With that said, depending on the deal, you may not expand the cap rate too much, if at all. For example, you are buying a value add play which you know can be sold as a development site in 10 years, you may not expand the cap rate more than 50 bps because a developer would be willing to pay up to get the deal due to profit margins allowing it. One could make the argument to handle the deal this way and get it thru investment committee. Some shops will be comfortable with this risk. Exit cap rates, unfortunately, may also be dependent on the fact that certain shops need to do deals - they need to get money out the door. Because of this, they may need to underwrite the deal similar to how the rest of the market is to win the deal, and determine, is this a smart risk and can I justify it. If so, they do it. The market may only be expanding cap rates 50 bps, and it’s the investors job to determine if they are okay with this risk.
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