Projecting future cap rates is a challenge for every commercial real estate investor. This challenge isn’t reserved for just new investors, it’s a challenge for seasoned pros as well. Yes, there are comps that can be pulled to provide some guidance, but the market environment has shifted so much that many of those comps are not reflective of today’s market condition, not to mention the future market.
What Is a Cap Rate?
Before we get ahead of ourselves, let’s establish what the cap rate is and isn’t. The cap rate is the expected rate of return investors seek on an investment. It is measured by dividing the net operating income by the property’s value. However, the cap rate reflects general market demand, not one person’s investment.
Think about the cap rate as the expected return investors will demand for an investment of a particular asset type, class, and sub-market — not the specific property. This allows us to anticipate demand based on the asset type, class, and location. With this information, investors can then determine if they are getting a deal or overpaying.
If B-class multifamily properties in a given area typically trade at a 5% cap rate on average, buying a property at a 7% cap rate would be considered a good investment because other investors have paid more for similar assets. Conversely, if you bought an asset for a 3% cap rate, on the surface it could look like you overpaid based on what others have acquired for similar assets.
Let’s use an example to illustrate this further.
Illustrating the Impact of Cap Rates
We’re going to buy a property with an NOI of $100,000 in an area where the market cap rate is 5%. Based on these figures, the property’s value is $2 million. If we were to buy this property for $1.9 million, that would equate to a 5% discount of the market value. Sweet deal. Let’s assume the property was stable and we couldn’t push the NOI, so the value should remain roughly at the $2 million figure.
On the other hand, what if we bought the same property for $2.1 million? We would be paying a 5% premium to the market value. Not such a sweet deal. However, if we had a plan to drive the NOI from $100,000 to $200,000, we would increase the value to $4 million. In that scenario, many investors are comfortable paying a small premium for the big upside.
All of this assumes the cap rate stays at 5%. If that number went up to, say, 6%, that sweet deal at the 5% discount starts to get a little sour. In fact, it will drop in value by $333,000, and we would lose $233,000 in equity, even at the 5% discount going in. And our value-add, big upside deal goes from an increase of $2 million to just $1.3 million.
The Importance of Projecting Cap Rates
Needless to say, projecting the exit cap rate is critical.
Many syndicators use a rule of thumb to add 10 basis points for every year they hold an asset. However, this rule of thumb may flip from being conservative to aggressive in a snap. Prime rates have increased to 8.25%. In just 15 months, mortgage rates rose from 3.6% (Jan. 2022) to 6.4% (April 2023).
Inevitably, the rising cost of capital has to force cap rates to increase…right? Despite this prevailing logic, cap rates remain relatively low but could certainly increase soon. For investors working on acquisitions, determining exit cap rates feels like aiming at a moving target while wearing a blindfold, after spinning in a circle three times.
How Should You Calculate Exit Cap Rates?
All of this begs the question: How should you calculate exit cap rates? I’ve spoken to a number of operators to gauge their answers to this question. Some are staying true to the approach they’ve always used, some are slightly altering their approach, while others are using alternative metrics to project future values.
Here are three suggestions for projecting exit cap rates and future values.
1. Traditional Approach
Many operators look for the stabilized cap rate based on market comps and add 10 basis points for every year they own the asset. This is assuming that they expect the market to be worse when they exit than when they purchase. Some operators are keeping the exit cap rates flat as they expect the future market to be better than the current market environment. The key here is to find the area’s stabilized cap rate, not just the going-in cap rate.
This approach has proven well for many operators who simply won’t veer from their traditional approach. The risk here is that the historic interest rate increases will force cap rates to rise at a rate higher than this traditional approach.
2. Conservative Adjustments
Several operators have decided that adding 10 basis points for every year the property is held is no longer sufficient based on current interest rates. They are opting to add 20 basis points or more per year. On a five-year hold, this assumes the cap rate will be 100 basis points or 1% higher when they sell.
While this approach is more conservative than the traditional approach, it makes it harder for deals to pencil in the current environment. Furthermore, given the historic rise in interest rates (almost 3% in just over a year), it’s hard to gauge if this is a sufficient approach.
While cap rates are important, there are other metrics to determine exit values. Some are paying closer attention to price per door and the averages in the submarket to make sure the exit projections are on par with historical figures. Some are taking a similar approach but focusing on price per square foot. On top of this, paying close attention to replacement costs provides some assurances on valuations.
Of course, none of these approaches is fail-proof, so determining which approach is best for you will come down to your market, asset class, experience, and risk tolerance. More importantly, savvy investors are focusing more on stabilized performance in anticipation of longer hold times.
This approach allows investors to refinance or sell when the market is optimal, as opposed to predicting exit cap rates in an uncertain market. It’s important to understand where exit cap rates could be, while still creating flexibility to navigate the uncertain market.
While some may sit on the sidelines, waiting for the market to settle, now is the time to find great opportunities. No matter how you calculate your exit cap rates, taking a conservative approach with your exit projections can be a crucial factor to protect your investment.
About the Author:
John Casmon has helped families invest passively in over $100 million worth of apartments. He is also the host of the #1 rated multifamily podcast, Multifamily Insights. Prior to multifamily, John was a marketing executive overseeing campaigns for Buick, Nike, Coors Light, and Mtn Dew: casmoncapital.com
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.