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Why do you assume the exit cap rate is higher than the acquisition cap rate?
Hi Michael. Thanks for the question. Although it might not always be the case for some assets, this is usually standard underwriting practice. We can think about the project in the context of both itself as an asset and within the context of the larger market in which it competes for tenants.
The building itself in this example will be ten years older at that point and, generally speaking, this means more challenges and risk associated with it. And more risk translates to a higher required return for investors, thus higher exit cap rate (or going-in cap rate for our future buyer).
Some of the challenges and risks we can assume at that time with the building being ten years older are (a) newer product in the market competing for tenants and making it more challenging to lease up and keep fully occupied and (b) higher risk for major capital expenditures required and more effort to upkeep and keep it competitive.
Again, this is not always the case as external factors also play a factor. Even with an aging building and new product in the market, if market demand is strong and new supply has not kept up with demand, cap rates can easily trend lower in the future despite the quality and age of the asset, growing demand and not enough supply in the market will keep pushing rents up and vacancy rates down. This translates into less risk for vacancy issues, and less risk to spend significant money on capital improvement to keep up with the market.
When underwriting a project, the exit cap rate can be a focal point of the analysis for the whole team and will be adjusted as the team assesses the market projections and refines the business plan.
Thanks for the question!
And not to beat this too much into the ground, but one other important piece of context is the risk premium spread for commercial real estate over the risk-free rate, which we usually peg to the US ten-year treasury. The assumption is that over time the risk free rate (10-year US treasury rate) will rise and that the spread will remain constant. If not, and the cap rate held while the treasury rate rose, then a virtually riskless investment’s return will grow to equal the same return as a risky real estate investment. In that scenario, no one would purchase real estate, so hence the additional rationale for growth in our exit cap rate.
Is there a typical spread that you look to see between your terminal cap rate and the discount rate you’ve applied?
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