Exit cap rate and IRR

[Dave Halevi]

Good evening guys, Thanks for all your help here!

There's a couple of things that I can't wrap my head around

1. When we buy a MF we can calculate the cap rate using the PP and NOI. But how cap I project what it would be selling for in 5 years?

also, it seems like I need to low my projected cap rate when selling so the building price would go up accordingly

2. How do I use the IRR to Project the sell price?

Thank you in advance for the patience! 

[Michael Le]

1. The cap rate is determined by the market so you don't just lower it to increase your building price. If it were that easy everyone would just lower it to 0% and make infinite money :) As for the projection in 5 years, that would be up to you do determine what the likely cap rate to be and get your investors to buy off on your projection. Cap rates are pretty compressed right now, historically speaking, so most of us right now are underwriting with some expansion in mind. Is that an increase of 50 basis points over 5 years or 100 or more, who knows?

2. That's not how it works. You can only calculate the IRR after you figure out the sale price, not the other way around. So using your projected sale price you can calculate the IRR and then determine if that IRR is sufficient for you to raise the money you need from your investors.

[Arn Cenedella]

To confirm @Michael Le comments.

The cap rate is determined by the market - location, neighborhood, age of building, quality of building, condition of the building etc. Class A newer buildings in Austin, TX may sell at a 3%cap. A class C older building in Huntsville, AL may sell at a 5% cap, etc etc etc. An apartment is a small town in the middle of nowhere with no job or population growth may sell at a 8% cap.

So the market determines the cap rate based on primarily location and age of asset.

To project sales price down the one road, one must assume (more accurately guess) what the cap rate will be. Standard procedure is to add 0.1% to 0.2% to the entry cap for every year of hold. So if you buy at a 5%, to be prudent one would assume an exit cap (cap rate at time of sale) to be 5.5% to 6%.

The IRR is an after the fact calculation and has nothing to do with projected sales price.

When underwriting a purchase projecting income and expenses AND exit cap in the future one can project an IRR. But it is not used in value calculation.

Hope this helps.

[Senate Eskridge]

This is going to take time and experience!  

The exit cap rate is an estimate or more of an art than a science, you have to know your market and your product.  Specifically, a Class A product in Austin is going to change at a different rate than a class C product in Oklahoma City.  As a basic rule of thumb, I INCREASE or decompress the caprate on my properties 15 basis points for each year I hold the property.  so if I buy at a 5 cap and hold it for 5 years then my exit cap rate would start at 5.75 and then I tweak it based of specific factors of the property market and location.  

As for IRR if you have a specific target in mind you can work backward to get the variables to hit that target but I don't think this is the best approach. you want to make sure you can execute the business plan first.

[Evan Polaski]

@Dave Halevi

As others noted, a 5 yr projection is an educated guess at best.  You need to plug in something, but none of us know what the future holds.  As Michael mentioned, conservative is expanding cap rates.  But if you find a deal that you can get for a 10% cap rate today, in suburban Dallas where rates are currently in the 3s for a lot of bigger product, you could probably get investors to buy into a 6% cap rate on exit and still look conservative. The issue is, you will likely be searching the rest of your life for that 10% going in cap in good sub markets in Dallas.  

So how do you turn a profit without compressing cap rates: you make the safer assumption that rents will grow long term. Many here focus on value add strategies, but even buying a brand new property, it is fairly safe to assume that rents will grow at least at a modest rate over time. if you can control expenses, so that rents grow faster than expenses, you will have higher NOI over time and therefore appreciation, even if cap rates stay flat. The faster NOI can grow, the more margin you build in to be able to sell at a HIGHER cap rate and still make money.

As others noted, typically you make an educated guess on sale price, based on NOI and projected exit cap to calculate your IRR. But, as Senate noted, if you are trying to hit an IRR threshold, you can at least run a test to start with IRR and use goal seek in Excel to determine the sale price to achieve that IRR. Then you can assess if that sale price is remotely reasonable based on NOI and current and projected cap rates.

[Dave Halevi]

Thank you very much guys, I appreciate this!

So assuming that I found a building at 7% cap. I'm trying to figure out what the "correct" or the "right" IRR rate would be

in order to determine whether it's a good deal of not.

I feel like I have a missing piece in my puzzle here :)

[Evan Polaski]

@Dave Halevi, that's the challenge, you need to determine that. If you are buying on your own, it is what you are comfortable with. If you are bringing in investors, it will really be dictated by their comfort level. There is no right or wrong. Some people/groups are buying deals that may pencil to a 9% IRR, and others won't touch anything that doesn't pencil to an 18%. But, as you are seeing, these are all assumptions, and small adjustments here and there can have big impacts. I.e. over a 5 yr hold, modeling 6% year over year rent growth will yield a much bigger NOI than 5%. And if you are in the 4-5% cap rate market, a 4.5% exit can project a lot more money than a 5%. Combine both, and you can swing a projected return dramatically.

[Dave Halevi]

Thank you very much guys for your answers!
Do you know any place that I can do a further reading?

[Arn Cenedella]

@Dave Halevi

There are lots of ways to learn about commerical real estate.

If you really want to take a deep dive to obtain a thorough understanding, i would recommend the CCIM program. 5 week long intensive courses. Online available. If that is more than you want to do, then….

You can find boot camps, meet ups, podcasts, summits and conferences.

There is NO ONE right or correct answer to any of this.

What type of investor are you? Long term buy and hold? Flip? Cash flow? Equity growth? Heavy value add lift? Or buy solid operational functioning properties and let time inflation and population growth win the day?

The answers to these type questions will guide you to the RIGHT return metrics for YOU. The answers to these type of questions will impact what is a GOOD investment for you.

Many investors swear “cash flow is king.”

For me, cash flow has never been king - total return and capital growth are MY king. So when I invest I focus on long term growth potential - the intrinsic quality of the asset rather than simply cash flow.

Easier to get cash flow in slower markets. I would rather sacrifice cash flow to buy in growth markets. Not saying my way is the right way simply this is my way.

What’s your way?

What do you hope to accomplish with your investing?

An investor with large amounts of capital is more inclined to take a longer term perspective and accept lower returns for lower risk. An investor with little capital might choose to be more aggressive - invest in riskier deals to get higher return.

What’s right for you?

Arn