Explain to me like I'm 5: Exit cap rate should be higher than going in cap rate

As the title says - please explains to me like I'm 5 on why the exit cap rate should be higher than going in cap rate, when considering inflation?

My understanding is cap rate = risk free discount rate + risk premium = NOI/ Value

Unless my formula above is wrong, I'm not following how inflation is a factor? Also, I always assumed the goal is to achieve cap rate compression. If exit cap is higher, does that mean you're losing money on the deal? 

Edit: Refreshed with the gordon model and looks like cap rate = risk free discount rate + risk premium - grow rate

I still don't understand why exit cap rate should be higher though

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Comments (39)

Apr 27, 2021 - 2:31am

No it doesn't mean your losing money on the deal.

Although the cap rate is higher, if you've done your job right as an operator (I.e. increased cash flow) the value you've created through (an increased) NOI should offset the value dilution from a widened cap rate spread.

No one wants to make a bet that value increases simply because cap rates compress. Real value creation has to come through NOI growth.

In a perfect exit, cap rates go down and your NOI goes up.

I had a flair for languages. But I soon discovered that what talks best is dollars, dinars, drachmas, rubles, rupees and pounds fucking sterling.
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Apr 27, 2021 - 3:53am

ELI5 answer - It's a way to stress test a part of the deal that the sponsor has little control over. Like the other commenter stated, value creation should ideally be through NOI growth and not pure price appreciate due to compressed cap rates.

Apr 27, 2021 - 7:49am

Price = NOI / CAP. It depends on the property type, but leases will generally have rent escalations tied to CPI. Rent is a very large part of CPI, so inflation and rent will generally move in tandem. What this means is that while your cap rate will expand due to inflation, you should also be getting increases in rents (theoretically even if doing nothing).

On the other hand, no prudent institutional investment manager is underwriting cap rate compression right now for certain product types (I.e. Multifamily), unless they believe they have encountered an opportunistic situation where an asset is fundamentally mispriced. This is rare and in most cases we assume 5bps (or more) of cap rate expansion per year in our models.

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Apr 27, 2021 - 8:25am

If you purchase a building unlevered for $1,000,000 for a 5% cap rate, the NOI is $50,000. Now, assume the building needs $100,000 of capital. So your basis is $1,100,000 and your yield on cost (NOI/ (Purchase Price + Total Capital) = 4.54%. If you assume you can get 10% NOI growth, your NOI is 55,000 and your yield on cost is now 5.0%. 
So now, if you sell the building for the same cap rate you bought it, you break even. You'll need cap rate compression to make a profit. That's risky. Why? Because generally, if the building has no upside, people need a higher cap rate due to the stabilized yield. Additionally, if your return is based on cap rate compression, what's the point of doing this deal? 

Now let's say you can increase NOI 40%. NOI is now 70,000 and your yield on cost is 6.36%. Well, if the market goes bust, and let's say you can sell the deal for a 5.75% cap rate, the building is worth approximately $1,217,391. That's appreciation of 10% over your basis. And it's conservative because your cap rate is higher than what you bought it at. Worst case scenario, if your can't sell the building, you own it at a 6.36 yield on cost while the market is 5.75% - you're making 61 bps for taking the risk of doing this deal above the 'core' sale cap. 

Now let's consider inflation. Due to inflation, your dollar you invest today is worth more than your dollar tomorrow. So your dollar tomorrow is worth less. Therefore, if you invest it today, you need to assume it will be worth less tomorrow. If it's worth less tomorrow, maybe instead of it being a 5.00% cap rate, the rate should be 5.01%. So over time, you need to increase the cap rate to assume this. Additionally, it stress tests your deal to make sure you are driving value by increasing income. Cap rates fluctuate but none of us know where they will go, so it's only prudent to assume they will increase, that way, we don't get caught off guard if that happens and it throw our deal down the drain. 

Apr 28, 2021 - 11:23am


Cap rates fluctuate but none of us know where they will go, so it's only prudent to assume they will decrease, that way, we don't get caught off guard if that happens and it throw our deal down the drain. 

Agree with all of this - but I believe you mean "increase" here, right? We should assume cap rates increase. If they do, we underwrote it and baked some conservatism in to our UW. And if they don't, we get some cap rate compression that juices our returns on exit. 

  • Analyst 1 in RE - Comm
Apr 28, 2021 - 10:43pm

So I have two questions:

1. If you have a 50,000 SF industrial property that has a tenant in place, NNN lease with 10 years of term left, rents are $10/SF. Ask is $10 million.

So you have for simplicity $500k NOI/$10 million = 5% cap with little upside besides escalation clauses in contract. Would the buyer see that it may be worth $10 million based on comps, but due to the fact upside is capped they will say I want to offer $9.5 million max. So they have some room and buy it at a higher cap rate ($500k/$9.5 million = 5.26% cap) to have some room in the deal?

2. I'm confused on your second paragraph, so to me lower cap rates = less risky asset right? So if I have that correct, why if a building is stabilized which to me can mean a range of quality tenant, but stable predicable income for x years wouldn't the cap rate be lower? Is this like the example above where the buyer knows the buildings true value, but in order for them to reduce the risk they're offering less than it's really worth to compensate and have some room for cap rate compression/market going bust/etc?

May 5, 2021 - 5:11pm

Not OP but I'll take a stab:

1. People don't buy stabilized, core real estate for the upside and wouldn't use that as a reason to lower the purchase price, you know what you're getting and you value it appropriately. The stabilized cap rate is really just the yield that someone is willing to accept on that investment given the future growth and associated risks (re-leasing, tenant bankruptcy, non-renewal, etc.). In your example, sure you can offer the $9.5 million, but, if it's truly a 5% cap rate market, then someone else will bid $10 million and you just won't win the deal. If you get it for $9.5mm then the market wasn't 5.0% in the first place. This obviously assumes markets are efficient, etc.

2.  When he says higher cap rate he's really just differentiating between a going in cap rate vs. a stabilized one, which doesn't really apply to stabilized deals. On a heavy value-add deal you might buy a deal at a current 4.0% cap rate, because after you finish your improvements, re-tenanting, etc. the building will be stabilized YoC at let's say a 6.0%. If the deal were stabilized day 1 you wouldn't have paid a 4% cap rate for the deal, you paid that because you thought you could end up at a 6% YoC.

Real life example (numbers/location changed, but based on what we're U/W) - we're looking at a value-add apartment deal on the west coast. If the deal were stabilized it would probably trade at a 3.75% cap rate today (it's on the beach, great location, uber core product, strong growth outlook, etc.). Our underwriting has us buying the deal below that (~3.3% going in cap rate), because we think we can put in the work to get our stabilized YoC to a 4.5%. When we sell we think it'll trade at a 4% cap rate, or 25 bps above today's stabilized cap rate.

Hope this helps.

Apr 27, 2021 - 8:32am

Predicting cap rates is hard because they are closely linked with interest rates. No one wants to try to accurately forecast cap rates, so they just say they will rise over the hold. This is the conservative approach. If you can make money with rising cap rates then you do even better in periods of falling/flat cap rates.

  • Intern in IB - Gen
Apr 28, 2021 - 8:28am

Just an incoming RE intern but could you explain why cap rates are linked to interest rates?

Apr 28, 2021 - 9:01am

break into cre on youtube has a few great videos explaining a lot of questions like these, if you're interested in real estate I recommend checking that channel out

Don't @ me

May 7, 2021 - 4:37pm

A lot of it is availability of financing. If I buy a building at a 4% cap rate and finance it at a 3% interest rate the debt is accretive to the deal. If interest rates jump to 5%, no bank will finance a deal you're buying at a 4% cap rate as the property can't handle that level of load. Also, no buyer would do that either as your levered return would be worse than your unlevered.

Apr 27, 2021 - 1:02pm

I always viewed exit cap rate expansion as a means to 1) offset any interest rate risk that might affect future cap rates and 2) act as a "catchall" to any operating assumptions you may miss (maybe your expenses will run a little higher than you thought, or maybe you don't achieve year 2 rent growth, etc.)

May 3, 2021 - 7:08pm

It really is more this than anything else.

Your rent bumps are too high - Well our exit cap is conservative

What if rates increase - Well our exit cap is conservative

What if the market moves - Exit cap is conservative

Construction Cost increase - Well we have a contingency and may still be profitable bc as construction cost increase caps decrease so our conservative cap rate catches this

Ect. for just about every equity question. However, people will get wrecked if cap rates actually do expand and the deal wasn't functioning for these other reasons.

  • Developer in RE - Comm
Apr 27, 2021 - 1:19pm

Lots of technical answers. But simply, your asset will be 10 years older in reversion year of your 10 year pro forma. Older building has more inherent risks (same way class B/C trade at higher cap than A). So you bake in a 25-50 bps spread. 

  • Analyst 2 in RE - Comm
Apr 28, 2021 - 2:22pm

OP here - Thank you! This explanation also makes a lot of sense. Let's see if I got this right - cap rate is really just a measurement on if you got a good deal. Ideally, you'd buy low (high cap) and sell high (low cap), but as the real world goes it's rarely the case, so you assume you'd sell low (high cap) to be conservative - is that right? 

  • Developer in RE - Comm
Apr 28, 2021 - 4:38pm

Good thinking, but almost there. Cap rate is a measure of risk. Yes, buy low, sell high - but a lot of this is already achieved through your NOI, which should grow over 10 years. Just taking Yr10 NOI (assuming it grows 3-5% each year) and slapping on it a cap rate 50bps higher than your entry should still get you a higher reversion value than your purchase price.

The same asset in Yr1 has less risk than in Yr 10 - due to older roofings, maintenance overuns, leases expiring etc...That's a simple way to think of it.

FYI, exit cap isn't always higher. Sometimes, buyers will get aggressive and underwrite no cap rate expansion (ie same going in and exit cap) for bullish markets. This happens during COVID time late last year, when aggressive underwriting was needed to get to ask price, especially when your Yr1 NOI was crushed by COVID related problems...But rule of thumb is 25-50bps spread between entry/exit for class A assets, may be more more older stuff.

  • Associate 2 in RE - Comm
Apr 27, 2021 - 5:19pm

Without diving into the technicals, building obsolescence is very real. Buy a newly-ish built apartment (~3 years), hold for 10-15 years, and suddenly that building is outdated. 

Apr 28, 2021 - 12:15pm

Lots of valid thoughts in these comments, but in reality there are many reasons why you might model a higher exit cap, and even some reasons you might model a lower exit cap. The summation of all of the reason for expanding an exit cap rate is to be conservative and defensible in your modeling. The actual rationale will depend on the specifics of the deal. 

Say I am buying a model home park that is 25% leased. I assume I can lease it up to 75% in 5 years and sell it. When I model that out and solve for my required return (say 14% LIRR), I might be willing to pay like a 3% cap rate on in-place NOI because of the low occupancy. A 75% leased mobile home park is not going to sell for a 3% cap, so I'll model my exit based on comp trades (considering cap rate and price per pad) and build in a margin of safety. Maybe it ends of being a 7.25% exit cap. 

Totally different example: I am modeling a NNN Arby's with 14 years remaining on the lease. It's listed at a 6% cap rate. When I go to sell it in 5 years, there are 1) 5 less years of contractual rent remaining, 2) 5 more years for a negative credit event to happen to the guarantor, and 3) 5 years of inflation and interest rate uncertainty. So similar to the first example, I'll comp out a 9-year arbys and add a margin of safety to account for #3. 

LOWER EXIT CAP: This can happen too. Say I buy a 3-tenant shopping center. One space has a dollar tree with one year left, one is a chinese restaurant with 6 months left on the lease, and one is a dry cleaners that just signed a new 10-year lease. I might buy the center for a 10% cap, model leasing up the two rolling spaces, and sell the stabilized center for an 8% cap. 

Moral of the story, the mechanics of each individual deal will impact your rationale for an exit cap. 

  • Analyst 2 in RE - Comm
Apr 28, 2021 - 2:20pm

OP Here - thank you! The Arby's and the shopping center examples really clicked for me - but not the 25% leased home park example. How come a 25% leased home park is more expensive (lower cap) than a 75% leased home park? Following the shopping center example, by de-risking/ leasing up the property and adding stabilized cash flow, wouldn't the property, which is the home park in this case, become more "expensive"? 

Apr 28, 2021 - 3:11pm

Because the NOI is so much lower. If you were to just apply a 7% cap rate to a 25% leased mobile home park, the dollar purchase price would be comically low (on a per pad basis, think PSF but per pad is common in manufactured housing) because of the small NOI due to vacancy. If firms can proforma a drastic boost to NOI over the hold period (the occupancy boost in our example, but it could also come from a mark-to-market of rent if rents are way below market, or perhaps a complete repositioning of the asset, such as buying a family car dealership, making minor CapEx, and leasing to SunBelt Rentals), then they are going to be able to pay more upfront and still hit their return threshold. 

Said differently, at a certain level of vacancy/distress, the cap rate becomes sort of irrelevant because NOI is so low. The intrinsic value of the asset is higher than any sort of logical cap rate value, so going-in cap rates look really low off of in-place NOI. If I bring this hypothetical manufactured housing investment to my investment committee, the model is going to show a 2% going-in cap rate, but no one will be paying attention to that, they will be scrutinizing the lease-up assumptions and maybe the price/pad we are paying.   

Apr 28, 2021 - 8:53pm

Lots of people mentioning inflation and cap rates...it is important to note that wider cap rates would be a result of future inflation being higher than current predictions of future inflation. That is, cap rates don't "inflate" as we go along, they follow interest rates. Values and NOIs inflate over time, but cap rates follow interest rates. 

May 10, 2021 - 8:05pm

I think to put it simply is that there's uncertainty looking forward. You don't know if industrials are still going to be trading at a 3.5% cap 10 years from now. So, you add a 50 point spread for the risk. It's typically 50-basis point spreads for a normal 10-yr hold of a core asset. You can get away with a tighter spread for less risky properties and shorter holds. Additionally, you may want to do the inverse

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