Underwriting Exit Caps
Hey gang — was wondering how those who work in asset underwriting predict their exit cap rates. Obviously there’s a number of ways to go about it, but none I’ve heard of are very scientific because of the fact that such a metric is typically 5+ years out. With that said it is one of the key factors in determining deal metrics (i.e. IRR, multiple, and net profit). My rule of thumb is always underwrite 50-100bps higher than the going in cap for stabilized properties, but will use discretion depending on the age of the asset, the sub-market dynamics, etc. Curious to hear what others have to say on the subject!
There are so many factors - I start with 10bps expansion per year, however i do have floors established for certain deals:
For example, if I am underwriting a shitty 70s property, 8' ceilings, 2x1 floorplans, without washer and dryer connections in an A location that is grossly mismanaged, the going-in cap rate might be somewhere around 4.80%. For this property, I would never underwrite an exit cap below a 5.50%, even a 5.75% exit cap would be tough to get through my investment committee. In 5 years this property will be almost 50 years old and getting more and more obsolete.
I am also mindful of my exit price per unit. If you are buying a newer vintage deal, expanding 50bps, and your exit value is 30% higher than replacement costs today, that is too aggressive. In this case I would expand a little wider.
@AB84 is right really. typically you want to be 25-50bps out for a 2-5 years hold and and 75 - 100 bps out for a 7-10 (who does a 6-year hold?)
I also look at price per lb. The best deals you're buying at below replacement cost and your residual is below today's replacement cost. That's a nice feeling.
If it is a shorter term hold I'll comp it against some recent deals also and decide on the residual cap based on those metrics (this is for value-add)
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