2 Different Approaches to Underwriting Exit Cap Rates

The process of underwriting commercial real estate is more of an art than a science. What underwriting means is the practice of analyzing a property’s past and present performance and forecasting future performance to determine the value of that property and understand the associated risks. In short, underwriting means looking at the historic financials of a property and making an assumption as to how that property will operate in the future. 

The canvas for an artist is synonymous with a financial model for a commercial real estate investor. The reason why underwriting is more of an art than a science is because there are numerous assumptions (i.e., inputs) that are made by an investor in a financial model. Those assumptions cannot be traced back to an exact science, but are rather predictions such as how a market will grow in the future, the speed at which a business plan can be executed, and more. 

In this post, we will talk about underwriting one of the most sensitive inputs in any underwriting model, the exit cap rate. For those who don’t know, a capitalization rate (i.e., “cap rate”) is equal to the net operating income of a property divided by the purchase price. Similar to any formula with 3 variables, so long as you have two of the inputs, you can solve for the missing variable. The reason why the exit cap rate is so important is because it influences the purchase price inside an underwriting model. For example, an investor may assume that their NOI will be $100k when they sell a property. If they factor a 5% cap at sale, then the property is hypothetically said to be worth $2M ($100k/5% = $2M). If that same investor factors a 6% cap rate, then the property is assumed to be worth $1.67M. Thus, the difference in an exit cap rate assumption drastically influences whether or not to pursue a project. 

At JP Acquisitions, we make it a habit to underwrite the exit cap rate to at least a 0.75% increase above the going-in cap rate. In other words, if the deal is being marketed at a 7% cap rate, we will factor in a 7.75% exit cap rate. This practice is very conservative because our exit cap rate assumption doesn’t factor in favorable changes in the economy or the full extent of the renovation plans that we typically pursue for our acquisitions. I’ll note that this habit of assuming a higher exit cap rate than what a property is currently trading at is an industry-standard, but the amount of the increase in the exit cap above the current cap varies depending on the investor. 

I’ve structured this post so that first I’ll cover the factors that affect cap rates. The two following sections then get into the meat of this post and capture the different approaches to underwriting cap rates. That said, let’s jump into this post.

1. Note – The definitions of the technical terms in any of our posts can be found in the glossary section of our website.
2. Note – I sometimes refer to cap rates as “cap” throughout this post.

Factors Effecting Cap Rates

There are numerous factors that influence cap rates. At the end of the day, a simple rule of thumb is that any component of a property that decreases the risk and increases the desirability of a property will decrease the cap rate and vice versa. Why? Lower risk means the chances of losing money (i.e., risk) are lower and investors pay for that. That statement is an axiom of finance. The following are some of the more common factors that affect cap rates:

1. Location: Location is a crucial factor in real estate. Properties in prime locations with high demand, good infrastructure, amenities, and proximity to employment centers tend to have lower cap rates compared to those in less desirable areas.
2. Property Age and Condition: Newer properties or those in excellent condition typically command lower cap rates because they require less immediate maintenance and renovation costs compared to older or poorly maintained properties.
3. Tenant Quality and Stability: The quality and stability of tenants, including their creditworthiness and lease terms, affect cap rates. Properties with long-term leases to reliable tenants generally have lower cap rates due to lower risk.
4. Property Size and Scale: Larger multifamily properties often have lower cap rates due to economies of scale and higher potential for rental income stability.
5. Operating Expenses: Lower operating expenses, including property taxes, maintenance costs, and property management fees, can contribute to higher net operating income (NOI) and, consequently, lower cap rates.
6. Renovation and Improvement Potential: Properties with potential for value-add opportunities through renovations, upgrades, or repositioning strategies may have higher cap rates due to the perceived risk associated with the investment.
7. Interest Rates: Changes in interest rates can impact cap rates. When interest rates rise, cap rates may also rise to maintain the desired return on investment relative to the perceived risk.

Cap Rate Expansion

As stated earlier, the conventional wisdom is to have a higher exit cap rate than the going-in cap rate of the property in question. Typically you will see one of two ways that investors underwrite for this. Either they simply assume the exit cap rate to be somewhere between 25 to 100bps above the current cap rate or they will inflate the exit cap rate by around 10bps per year of the hold period. We take the former approach at JP Acquisitions. 

This strategy is inherently conservative and takes into account a wide array of potential scenarios and factors that could negatively impact a deal. The beauty behind this strategy is that if cap rates stay the same or compress, then the returns of the deal can go up drastically. The downside is that the number of deals that will fall within your target returns is lower which results in potentially fewer deals being done and the possibility of missing out on some homerun deals. 

Regardless of the economy and where interest rates are, I believe this strategy is the right way to go about underwriting commercial real estate. Why? You never know what will happen in the future and it’s better to do fewer deals with a higher margin of safety than vice versa and risk losing money and reputation. As Warren Buffet said, “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.” Warren Buffet said this because the power of compound interest allows for outsized returns, but I digress.

Cap Rate Compression

While I stated that I prefer the cap rate expansion strategy, there is a good argument to be made for the other side in today’s market. If you believe that we are at a cyclical high in cap rates, then assuming that the exit cap rate will be lower than the going-in cap holds some weight. The truth of the matter is that in recent years cap rates have been rather low due primarily to where interest rates have been. Since 2022, the Federal Reserve has hiked interest rates 11 times to the highest we’ve seen in over 20 years. Looking forward, the Fed has signaled that they are looking to lower rates in the near future as the economy has made progress towards the Fed’s goals (i.e., dual mandate) of maximum employment and price stability (i.e., 2% inflation). If the fed were to decrease the Federal Funds Rate, that would in turn lower interest rates which would then cause cap rates to compress/decrease as the cost of debt would be lower. 

I can see why this approach is alluring and even sophisticated investors could be drawn to this approach. The thought here is that it’s crucial to adapt to market trends and take advantage of opportunities. More so, the market investors face today is characterized by increased exit caps, lower rents, higher construction costs, and higher interest rates which have resulted in fewer developers building new assets. This could potentially mean that some investors outperform as supply constraints lead to higher rents. In the multifamily space, a perfect storm is brewing as many people cannot afford homes because of high-interest rates and the supply of single-family homes being low due to homeowners showing reluctance to give up their low interest rate mortages. 

All this is to say that in today’s market, there is an argument to be made for underwriting to decreasing cap rates. However, there are simply too many factors at play to say that for sure one strategy is better than the other. 

Conclusion

In this post, I have outlined the two approaches/strategies that investors can take when underwriting exit cap rates. What makes this topic complicated is the fact that there are many investment strategies out there of which one approach of underwriting exit cap rates can make more sense than the other. What can be said for sure is that underwriting for cap rate expansion as opposed to compression is a more conservative approach and the one that has been more widely adopted in the industry.

If you have any questions regarding the terms and concepts in this post or previous ones, please reach out to either me (tedi.nati@jpacq.com) or someone on our team so we can help explain further. If you’re interested in investing with us at JP Acquisitions, you can contact us via our contact form, by emailing a member of our team, messaging us on LinkedIn, or signing up for our investor portal to set up a meeting.

As always, I hope you enjoyed reading this post as much as I have writing it. Best of luck!