hi everybody, was wondering how people here determine their exit cap-rate. Is it just off of comparables (even then, finding a future comparable isn't really possible when modeling the properties performance for the next 5-10+ years). I've read it can be done off of historic cap-rates, but a neighborhood can develop a lot in a 5-10 year time-span, so using historic rates doesn't sound particularly accurate.
I understand the math for going-in caps and exit caps, that's easy enough. Hypothetically speaking though, couldn't a person just buy a property at $1,000,000 with a 10% cap rate ($100,000 NOI) and 5 years later sell it at a 5% cap, and lets assume the the last years NOI is $125,000 making the sales price $2,500,000.
My point being, although the NOI did make a 25% increase in 5-years time, but does that really support the additional $1,000,000+ at the sale? that's a 150% increase! If it remained a 10% cap with an NOI of $125,000, then it'd only be selling for $1,250,000.
So, there must be some other determiners or market influences for exit cap rates, otherwise people would just buy a property at a 10 Cap and flip at a 4 Cap, and defend it by saying "the numbers make sense", right?
The scenario you've described going from 10 caps to 5 caps is what we've seen over this market cycle. It's called cap rate compression, and while it's great for investors it's also outside of our control.
Cap rates are really a metric for what the market is willing to pay for current and future cash flows. They are related to but not directly tied to market interest rates. Since the great recession interest rates have been incredibly low and real estate has returned to its former popularity, so the market has been bid up and cap rates have gone down.
In my opinion one must include some degree of cap rate expansion in one's underwriting these days to be conservative.
When folks first get into commercial they tend to overestimate the importance of cap rate. Now, cap rates do matter, but many other factors do as well. DSCR, Break even occupancy, cost per square foot or per unit, gross rent multiplier, expense ratio, etc.
Cap rate is not a direct metric of how profitable your operation of the property is, and cash flow metrics should always come first (in my opinion). Most investors will look at cash on cash return and IRR to determine whether they want to invest in a particular property.
Your return will most likely not come from buying a property at a 10 cap and repositioning it to sell at a 4 if you're buying a non distressed property. That would be a heavy lift, because there's a reason the market is willing to pay 10 cap when you buy and 4 cap when you sell. For non-distressed properties, your return will likely come from raising the NOI with some modest change in entry-exit cap.
Don't worry about Cap rates, you don't get to "pick" them.
Now, you can engineer them with your asking price or your NOI.
Price- your decide the asking, but the market decides the value. How long do you want it on the market? How are you marketing it? What usages can it be marketed for, "Best use"? Comparisons versus market competition- Door sizes, cleanliness, location- can't change- unless you market to a certain business that fits that type of location, parking, How do you create more value versus similar properties?, etc.
NOI- keep in mind you are basically talking financials. Specifically Operating expenses and not Depreciation, interest, or income taxes. Pick your largest items and make plans to reduce them in your last year, prior to CAP rate year. You then have to decide what you reflect in Pro Forma if you do them. Sales Adjustments or write-offs, utilities, property tax, insurance, labor, repairs/maintenance, etc. Now you have to ask yourself, your business ethics, horse trading, or Caveat emptor position.
Sales Adjustments or write offs- if you have receivables, clean them up the year before and don't clean them up during the year of your cap rate calc.
Utilities- adjust them down if possible. Turn your night lights from dark to 3am versus dark to 7am. Turn heating and cooling down. "Cash Basis" accounting- prepay in the prior year and don't pay until after your Cap year.
Property Tax- "Cash Basis", prepay in the prior year and don't pay in the Cap year.
Insurance- reduce insurance or don't have it at all. Or "Cash Basis", prepay in the prior year, or move your coverage period to the next year.
Labor or management fee- don't report it. Pay Cash.
Repairs/maintenance- figure it out.
Don't worry about Cap rates.
1. We always reconstruct the financials on properties we are analyzing. That way we "own" our numbers. We have looked at properties with CAP rates, where unknowingly or who cares, the Property tax and management fees were left off the financials and listing; and the projections.
2. Property Aesthetics, value- we inspect the properties. If we miss something its on us. We "own" the analysis of the property. When you go to market, show the non-numerical or the hidden value.
3. Are the financials and market (rent rates) sustainable. Again, we analyze and "own" the analysis. If the owner/realtor says the current tenants have 5 years remaining, I want to see the lease. Want to see the terms of the lease. A 5 year lease with exit upon 1 month notice, is not a 5 year lease. Have they actually been paying their rent, or is it tied up in receivables. I have seen 10 year leases with 1 month out notices.
Worry about CAP rates:
Most investors are Financial investors and not operators. Thus CAP rate is important in marketing to them. That is how they are filtering and comparing similar assets. We looked at an investment 1,000 miles away. Did the numbers. Looked at it on Google, looked clean. Realtor said he had over 70 calls, even from Mumbai on the property. Thought 50 were serious buyers. I decided to drive down and look at the property a week before, they sent out an "updated" offering. Was priced at a ridiculous price. No one had made an offer. I was prepared to make an offer, which the Realtor thought would be acceptable. Got out, looked at the property. Very clean operation. Decided within 5 minutes we could not make an offer. "Saw" something.
Property A- $1,000,000 list; NOI $125,000
Property B- $1,000,000 list; NOI $125,000
See one of my prior posts. I pick Property B, hands down, all day long. Even though CAP rates are the same. Look beyond CAP rate.
My point is CAP rate will get them to look or not look. After that it is Caveat Emptor.
"Start small and Make Your Big Mistakes Early"