Exit Cap Rate

maddux's picture
Rank: Baboon | 162

Let's say you are purchasing an asset at an 8 cap and that you will hold the asset for 5 years and you generate 5% YoY NOI growth. Where would you want your exit cap to be? We all know how IRRs are sensitive to cap rates since they drive your purchase and exit prices. I know that at times people want to exit at the same cap rate, others look to exit at 75 to 100bps lower and others are fine exiting at a higher cap than they bought at. Since a lower cap rate drives the value of your asset up, wouldn't you want to exit at a lower cap?

If you're experiencing NOI growth, the value of your property goes up since it generates more income, does it mean that your cap rate goes down?

As an investor, what do you want to do to the cap rate when you purchase a property?

Question for experienced investors, what does an 8% cap rate tell you? Do you see it as 8% gross unleverred return prior to tax and interest expense? In that case wouldn't you want your cap rates to go up?

Sorry my thoughts are all over the place but I am having a hard time fully understanding the concept of cap rates.

Comments (11)

Nov 12, 2012
maddux:

If you're experiencing NOI growth, the value of your property goes up since it generates more income, does it mean that your cap rate goes down?

No.

NOI (increases) / cap rate (unchanged) = value (increases)

An increase in NOI causes an increase value. The cap rate isn't a function of NOI. It is determined more by instinct and experience based on how your asset/situation compares with other transactions in the market with similar assets.

Typically higher cap rates signify greater risk because the buyer is requiring more net operating income for the same purchase price than of a less risky (lower cap rate) asset.

As an investor you obviously want the cap rates to go down when you own the asset much like you want interest rates to go down when you own a bond. It drives the price higher.

Nov 12, 2012

I think you misunderstand. The change in cap rate is a determined by the relevant market conditions, not NOI. If the cap rate drops, this is favorable for the seller, and if it rises, it is detrimental to the seller.

You cannot really change the cap rate.* It affects what you can reasonably hope to get when selling the real estate.

Here's a way to think of it: Think of a building as though it's a bond. The yield (which is roughly the same as the cap rate) may go up for bonds, due to a movement of capital into stocks. Since bonds all pay out a fixed income (basically, the NOI), this change in yield causes the price to drop, so that the fixed payout becomes the "right" percentage of the bond's price (value). So if the market conditions cause the going cap rate to drop, the building can sell for more, to make the ratio of NOI/Value "correct" given market conditions.

Bond investors may make fun of me for how I explained that, as I have never invested in bonds.

*I suppose one could shift the building into a different market sector with a different cap rate by switching a building from residential to commercial, zoning codes permitting. The cap rate is often different between sectors, and this could conceivably change things in the seller's favor. In practice, this is a highly unlikely state of affairs.

    • 1
Nov 12, 2012

Thank you, it is very helpful to think about it as a bond. Bond investors can hardly control the yield since the market drives it. My guess is that the same goes for cap rates as they are a market measure. Finally this is all making sense.

So if I tell you that a Class A mall is trading at a 5.5% cap and a class B shopping center is trading at a 8% cap. The investor buying the class B center will ask for a higher return than the investor in the class A mall, am I correct? Kind of like investment grade and non investment grade?

Nov 13, 2012

You're welcome!

If I'm reading you correctly, you've got it worked out: the investor will get the higher or lower return because he will have to pay less or more money, respectively, for the properties.

Nov 13, 2012
maddux:

Let's say you are purchasing an asset at an 8 cap and that you will hold the asset for 5 years and you generate 5% YoY NOI growth. Where would you want your exit cap to be?

8.5

    • 1
Best Response
Nov 13, 2012

Just to add: All things equal (market cap rates for similar assets are stable, leases are stable, etc.), the going-out cap rate will be higher. Why?

Assuming the property is not a Class A office building in a primo location (NY, DC, SF, etc.), the cap ex spent to maintain the property will be less than the amount required to offset the physical depreciation of the property.

IE: A 2009 car with 10,000 miles is worth less than a 2010 car with 10,000 miles. Similarly, a well-maintained 10-year-old property is worth slightly less than a well-maintained 5-year-old property (given equal NOI, tenants, etc.)

Thus the cap rate reflects this difference, and thus should be the same, if not higher than what you purchased it at.

    • 2
Nov 14, 2012

Real Analysis has it right. If you are going with a lower exit cap rate then you are assuming a better market in the future. That is a good way to get smoked. When underwriting you should take a conservative approach and go with a higher exit cap. There are others way to add value to a property beyond just NOI.

    • 1
Nov 28, 2012

Yield forecasts, empirically, have been seen to be atrocious. Unless you're repositioning an asset, use the entry cap rate. If you are compressing the cap rate for the sake of it, you're either saying that prices on aggregate are improving, or that the economy is flying. So, just use the yield @ purchase.

    • 1
Nov 28, 2012

Or, if you want to be even more careful, do a sensitivity table and see what happens at a variety of yields.

    • 1
Dec 12, 2012

.

Dec 15, 2012
Comment