RE MACRO OUTLOOK

Based on the most helpful WSO content, underwriting (UW) a 100bps cap rate compression by year 5 can be challenging to substantiate, especially in the current market environment. Here are some considerations to help you justify or adjust your assumptions:

1. Market Trends and Historical Data:

   • Cap rate compression has been driven historically by factors like low-interest rates, abundant capital, and strong rent growth. However, recent discussions on WSO suggest that cap rates are expanding in many markets due to rising interest rates, shrinking liquidity pools, and investor skepticism.
   • For example, some threads highlight cap rate expansions of 100-150bps in certain processes, reflecting a shift in market dynamics.

2. Interest Rate Environment:

   • Rising interest rates are a key driver of cap rate expansion. If debt costs are increasing (e.g., quotes starting with 5% or 6% for leverage), it becomes harder to justify compression unless there’s a strong counteracting force like exceptional rent growth or supply constraints.

3. Asset-Specific and Regional Factors:

   • Cap rate trends are highly asset-type and region-specific. For instance, well-located value-add multifamily deals may still see strong interest, but commodity-like assets are facing less demand.
   • Consider the specific market dynamics of your asset's location and type. Are there unique factors (e.g., supply constraints, demographic trends) that could drive compression?

4. Investor Sentiment and Dry Powder:

   • Some WSO threads mention that abundant dry powder in the market has kept return metrics (like IRRs) compressing, which could indirectly support cap rate compression. However, this is contingent on continued capital inflows and investor confidence.

5. Stress Testing and Conservative Assumptions:

   • A widely accepted industry standard for future sale valuations is to assume a cap rate expansion of 5bps per year. This conservative approach aligns with the idea of underwriting stabilized year 11 NOI at a higher exit cap rate.
   • If you’re holding 100bps compression, ensure your model accounts for stress scenarios where this assumption doesn’t hold. For example, what happens to your returns if cap rates expand instead?

6. Substantiating Compression:

   • Use rent growth projections, supply-demand imbalances, and comparable sales data to justify your assumption. If your market has strong fundamentals (e.g., limited new supply, high population growth), it may support compression.
   • Highlight any unique factors that differentiate your asset or market from broader trends.

In summary, while 100bps compression by year 5 is aggressive in the current environment, it could be substantiated with strong market fundamentals and a clear narrative. However, given the macro outlook, it’s crucial to stress test your model and consider more conservative scenarios to ensure feasibility.

Sources: Are cap rates still compressing?, Cap Rate expansion in multifamily/development?, State of Market Discussion, A Discussion on Interest Rates/Macro Fundamentals (Long OP), 2020: Real Estate Bonuses