Cap Rate Compression

Multi-Family and Apartment Investing
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Cap Rate Compression

Alberto M.
Rental Property Investor · Miami, FL · Member since 2018 · 67 posts · 25 votes

I'm sure everybody here knows what a cap rate is, if you don't, a cap rate is basically a measure to understand your rate of return based on NOI (net operating income) the property is intended to generate.

In general terms, it is a simple formula:

Cap rate = NOI / Purchase Price

So far so good, however, it starts to get tricky when we talk about cap rate compressions. This happens mostly when the value of a house increases (due to let's say market factors) and the NOI stays the same, decreasing the cap rate (compressing).

Until this point I understand it perfectly and I hope was able to explain it clearly to those that didn’t know about it. My questions comes on how to determine a cap rate compression in a proforma for a project you are planning to acquire?

A couple weeks ago I received an Offering Memorandum for an investment opportunity and it had a proforma for 5 years. In the cash flows I saw that on year five they will intent to sell the property with a cap rate compression.

How can you know if that assumption is conservative or aggressive? How can you project a cap compression in 5 years from now?

I hope this helps as well as if someone can help me understanding this I would really appreciate it.

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Charles Seaman
Apartment Syndicator · Charleston, SC · Member since 2017 · 519 posts · 631 votes
6y

@Alberto M. Unfortunately, there really is no exact science to accurately predicting a future cap rate because none of us have a crystal ball.  Most groups typically underwrite deals with the assumption that cap rates will be higher when they sell a property than when they buy it (and that's probably a very good idea in the current time).  On the low side, I've heard of groups using a terminal cap rate that's 0.5% higher than the acquisition cap rate.  On the high side, I've heard 1.5% higher than the acquisition cap rate.  While it's great to be very conservative and use a terminal cap rate that's 1.5% higher than the acquisition cap rate, it'll also likely make you unable to be competitive on most deals.

The best suggestion that I can offer you is to really know the area that you're looking to invest in and to study historic cap rates.  Look at what cap rates were when times were good and when times were bad and also assess where that particular area was when those conditions applied in comparison to where it is now.  Past performance is no indicator of future results, but it is the best resource that we have available to us (unless somebody has a crystal ball).

Lastly, the other reason that cap rates will likely stay compressed, even in a down market, is due to the increase of dollars in the money supply.  As long as the government keeps the printing presses on, then people will have more dollars to throw at investments.

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  • Charles Seaman
    Apartment Syndicator · Charleston, SC · Member since 2017 · 519 posts · 631 votes
    6y

    @Alberto M. Unfortunately, there really is no exact science to accurately predicting a future cap rate because none of us have a crystal ball.  Most groups typically underwrite deals with the assumption that cap rates will be higher when they sell a property than when they buy it (and that's probably a very good idea in the current time).  On the low side, I've heard of groups using a terminal cap rate that's 0.5% higher than the acquisition cap rate.  On the high side, I've heard 1.5% higher than the acquisition cap rate.  While it's great to be very conservative and use a terminal cap rate that's 1.5% higher than the acquisition cap rate, it'll also likely make you unable to be competitive on most deals.

    The best suggestion that I can offer you is to really know the area that you're looking to invest in and to study historic cap rates.  Look at what cap rates were when times were good and when times were bad and also assess where that particular area was when those conditions applied in comparison to where it is now.  Past performance is no indicator of future results, but it is the best resource that we have available to us (unless somebody has a crystal ball).

    Lastly, the other reason that cap rates will likely stay compressed, even in a down market, is due to the increase of dollars in the money supply.  As long as the government keeps the printing presses on, then people will have more dollars to throw at investments.

    4Reply
  • Greg Dickerson
    Developer · Charlottesville, VA · Member since 2018 · 4k+ posts · 4k+ votes
    6y

    CAP Rates are only meaningful when evaluating stabilized assets. You need to look at the financials of the property and determine if it works for you and your business plan. Nobody can predict the future and where values will be a year or five years from now so you need to be OK with the property as is right now. We do know if Supply increases exponentially, interest rates rise, capital dries up or debt becomes more difficult to secure values will certainly drop.

    The only thing you can predict with any amount of certainty is whether or not you can increase the income through stabilization, operational efficiencies, rent increases, other revenue centers etc.

    2Reply
  • Alberto M.
    OP
    Rental Property Investor · Miami, FL · Member since 2018 · 67 posts · 25 votes
    6y

    @Charles Seaman

    Great feedback Charles, thank you!

    1Reply
  • Alberto M.
    OP
    Rental Property Investor · Miami, FL · Member since 2018 · 67 posts · 25 votes
    6y

    @Greg Dickerson thank you Greg.

    I see you are a developer. As a developer, let's say you build a 30 unit property, but you intend to keep it after finishing construction, rent it out and hold it for 5 years to receive rental income. In your proforma to analyze if it's a good investment or not you will have two pieces: the whole construction side and the Holding period with income and expenses. Now let's say it will take 7 years (2 to build and 5 holding it), then you intent to sell it. How can you determine your terminal cap rate at this point? If you are raising capital, your investor would want to know how much money you will return to them and the only way will be by stipulating a selling price. Do you take your same cap rate you had when stabilizing the building and just update the NOI (as it will be higher in 5 years), or do you apply a cap rate compression?

    Any advise on your experience? Thank you!

    0Reply
  • Evan Polaski
    Cincinnati, OH · Member since 2020 · 4k+ posts · 3k+ votes
    6y

    @Alberto M. As Charles mentioned, you need to know your markets. Development and acquiring properties are the same.  One you spend money and time building, the other you spend money buying, but from a financial standpoint, your model doesn't care.  It is all about timing of cash flows to yield a return.

    That being said, it is all a guess.  An educated guess based on where things have traded in the past, blended with your outlook on the future, given the variables that Greg mentioned.  But it is a guess.  That is why, as Charles mentioned, smart operators place what they feel are conservative, but realistic, guesses on exit valuations.  

    If you were investing, you go to sell a property that was underwritten and purchased 5 years ago and you sell at a 7% cap rate.  As the investor would be happy or upset if the underwriting was based on an 8% cap rate?  How would you feel if the underwritten cap rate was 6%?

    1Reply
  • Alberto M.
    OP
    Rental Property Investor · Miami, FL · Member since 2018 · 67 posts · 25 votes
    6y

    @Evan Polaski

    Thanks for the feedback Evan!

    0Reply
  • Dallon Schultz
    Rental Property Investor · Phoenix, AZ · Member since 2019 · 146 posts · 77 votes
    6y

    @Alberto M. every market will be different so knowing how appraisers, lenders, and brokers are evaluating deals in your local market would be key. If your market has a strong history of job and population growth and supply is low thus increasing the demand then typically one could choose to be a bit more aggressive with the reversion cap. What I have heard and used as a general rule of thumb in our underwriting of properties is a reversion cap of 10-15bps per year the property is held. For example, if your subject property is purchased at a 5% cap and your plan is to hold for 5 years, give yourself a reversion cap of 5.5-5.75%. Bottom line is no one has a crystal ball and knows for sure so the key is to obviously be conservative while remaining competitive and know what your market supports.

    1Reply
  • Steve Morris
    Real Estate Broker · Portland, OR · Member since 2019 · 4k+ posts · 2k+ votes
    6y

    My questions comes on how to determine a cap rate compression in a proforma for a project you are planning to acquire?

    Am a broker and due to reporting bias, CapRates are BS. Are they based on real numbers or did the listing broker do a ProForma (i.e. make up very optimistic stuff)? You can get radically different numbers for the same property. If you have real representative (i.e. not a lot of CapEx done which is NOT an operating expense), I'd rely more on them to figure my potential return.

    Probably the most consistent best curve-fit indicator is $/SqFt.  You can't fudge on price or SqFt.  Plus it compensates somewhat for unit mix as studios are <<< sqft than 3 beds.

    1Reply
  • Kevin K.
    Specialist · NY · Member since 2016 · 82 posts · 60 votes
    6y

    I’d say it’s aggressive. 

    I would caution against using a lower terminal cap rate(last year) then the going-in cap rate (first year). 

    Generally your terminal cap rate is 25-75 basis points higher than your going-in cap rate. Mostly because the building will be older and may not have the same income potential as it had in the beginning of the holding period. Moreover, the increased rate is also used because of additional uncertainty associated with estimating what the cash flow will be when the property is sold to the new owner. 

    As others have already mentioned, any future assumptions can have a notable impact on value if those assumption turn out to be wrong. This is generally why Multifamily is valued based on current market derived cap rates using the Income Approach assuming a stabilized occupancy of the coming year. Simple IRV formula Income/rate = Value.

    Can you post a redacted copy of the OM? I’m curious to see how this was layed out or if they have any support for the lower terminal cap rate.  

    2Reply
  • Alberto M.
    OP
    Rental Property Investor · Miami, FL · Member since 2018 · 67 posts · 25 votes
    6y

    @Kevin K.

    Hi Kevin,

    Thanks for your input, you have no idea how helpful this is.

    I totally agree with you, the more compression you apply to you going in cap rate the more aggressive and risky the investment is.

    Now, is there and factual or statistic explanation on your rule of thumb of adding 25-75 basis point to your terminal cap rate? Can you elaborate more on the reasoning behind this cap inflation?

    Second question, could you expect or project the same inflation to your cap rate for any type of multifamily? More specifically, I got invited to an opportunity to develop a multifamily property in Florida. The numbers look good but they are using the same going-in cap rate as the terminal cap rate (which I find aggressive but maybe it’s because it’s a new construction). How could I look at cap rates for new developments?

    Thanks in advance!

    0Reply
  • Alberto M.
    OP
    Rental Property Investor · Miami, FL · Member since 2018 · 67 posts · 25 votes
    6y

    @Dallon Schultz does this reversion cap rate applies for all type of multifamily? Can you elaborate more on the logic behind this rule of thumb?

    Thank you so much!

    0Reply
  • Kevin K.
    Specialist · NY · Member since 2016 · 82 posts · 60 votes
    6y

    It’s more of a rule of thumb like Dallon said above. Also, it can be a way of “stressing” the deal. In other words if your desired rate of return is 10% and you know the deal will work even if cap rates increase slightly 25-75 basis points then your good to go. If cap rates remain flat, then your expected rate of return will increase over your desired 10% target. 

    On the other hand, if you need cap rates to compress 25-75 basis points. And they remain flat your desired rate of return will drop below your 10% target. 

    In regards to new construction. They can be fine, as the other poster has said it can be an annualized increase of .10 -.15 BPs. Without seeing the deal I’m assuming it’s a 1-2 year completion, so that’s not as alarming. However, due to market conditions (Covid, unemployment, etc) I will still “stress” it at a higher terminal so rate. Even a 50 basis point increase over the next few years isn’t a huge jump. I tend to be more conservative on things, so other opinions my differ. 

    The biggest issue with any new construction is the sponsors experience. I would ask to see the financials of past projects and his other accomplishments. In other words, I would underwrite the sponsor just as much the deal/project.  

    1Reply
  • Dallon Schultz
    Rental Property Investor · Phoenix, AZ · Member since 2019 · 146 posts · 77 votes
    6y

    @Alberto M. that was information I’ve received from commercial lenders, appraisers and brokers in the Phoenix market. As Kevin mentioned its a rule of thumb. Different markets and different asset types even within multifamily may require a more aggressive or conservative approach. My recommendation is if you want to obtain a more accurate number contact those in the area you’re investing in and inquire what’s most appropriate for that market.

    1Reply
  • Kevin McGuirePro Member
    CTO of BiggerPockets · Seattle, WA · Member since 2019 · 178 posts · 178 votes
    6y

    I have no insights, only bewilderment :) What confuses me about any projection is the fact that the market forces on rent and those on property value are only loosely correlated. For example, I’m guessing that today we’re seeing cap rate compression since renters have less cash for rent, but low interest rates are driving up prices. At least that’s what I’m seeing for my properties. Seems the only thing you might predict is operating expenses which on a stabilized property might be kept in check for a 5 year period. I understand though for commercial, the value *is* a function of cap rate, so maybe I’m thinking about this wrong.

    1Reply
  • Spencer Gray
    Syndication Expert and Investor · Indianapolis, IN · Member since 2016 · 591 posts · 808 votes
    6y

    When we underwrite multifamily acquisitions we estimate what we believe is a reasonable terminal cap rate would be in the year of a sale, often the going in cap rate although sometimes we'll use a compressed or expanded rate depending on the asset and market. We then build a sensitivity analysis table with 25 bps spread 200 bps in either direction outputting the resulting IRR.

    By keeping our baseline assumption neither overly aggressive or conservative we can use the sensitivity table as a lens for either strong or weak market conditions. As other's have said, it's impossible to predict the future. 

    That being said it's not only important to look at historic cap rate levels but also their relationship to interest rates over time and the long term trajectory of interest rates and inflation in general. Also comparing market periods with significant supply of housing like in the late 70's-80's, early 90's, and late 00's vs today with a significant supply/demand imbalance. 
     

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