Everything You Need to Know About Exit Cap Rates in Multifamily Real Estate

A lot of investing is the art of navigating risk.

Investors want you to project what the investment is going to return them, even though so much is out of your control.

You want to get your assumptions and business plan as certain as you can can, however there will always be an element of going into the unknown for all investors.

One of the biggest assumptions is at what cap rate you can sell the property for in 5 years upon an exit.

This is called several things in commercial real estate such as:

Exit cap rate

Reversion cap rate

Terminal cap rate

All are referring to the same thing; the cap rate you're projecting on an exit.

How much does your exit cap rate affect the returns of the deal?

NOI / Cap Rate = Value

$100,000 / .06 Cap Rate = $1,666,667 Value

$100,000 NOI / .05 Cap Rate (5 Cap) = $2,000,000 Value

$100,000 / .04 Cap Rate = $2,500,000

What is shown above is something I have never heard anyone talk about.

Notice the difference between a 6 cap and a 5 cap is $333,333.

The difference between a 5 cap and a 4 cap is $500,000.

Both are a 1 cap rate spread, but largely different.

What does this mean?

That when someone compresses the cap rate on a deal underwriting pro forma, it's going to be a much larger change than if the cap rates decompress. This change will be shown in the profit projections that they advertise.

How much does the exit cap rate affect the risk of the deal?

This image above is the projected returns of the deal at different exit cap rates. It's important to note that this deal was also a value add and the business plan of renovating units and raising rents are accounted for. The 1.79x etc. numbers are the equity multiple metric for investors.

The main risk is if cap rates decompress, rents drop, and you're in a position where your loan is expiring and must sell.

Again, this points to the importance of long term debt because you can ride out storms.

What exit cape rate should you use?

There is no hard rule into what you need to put because ultimately it's a complete prediction.

To be conservative, it has been taught to increase the cap rate 10 basis points per year from your T12, or T3 whichever reflects a more accurate number.

What are people using today Nov 2023?

In the markets I look at such as markets in Texas, going in cap rates are usually between mid 5s to 6 on B class assets.

To make numbers work, which is rare, the deals I've seen under contract are underwriting for over 50% down payment in addition to compressing cap rates 50 to 100 basis points.

Cap Rate Compression and Decompression

With multifamily real estate, almost always is there an element of value add.

Depending on how much value add you can do, you can compress the cap rate, or even decompress it.

Wait, how would I decompress a cap rate by renovating it?

First, we'll talk about the more obvious one.

You can compress a cap rate say on a opportunistic deal where you drastically improve the property. Say you can make the deal look much better and raise occupancy. When it's stabilizes, you now have a deal to sell that is much more operational. You may purchase at an 8 cap on paper and now it's valued at a 6 cap.

Where it can decompress is when you take the upside of the value add out of it and don't leave any "Meat on the bone."

Say you find a 100 unit C class property where 75% of the units are still in classic condition at a 4.5% cap rate. You decide to renovate all of the remaining units and increase rents.

What you've done is, yes, raise the NOI significantly with your rent increases from renovations, but you've also eliminated the opportunity for the next buyer to do the same.

The next buyer would have to buy it as if it's a mere yield play with minimal to no value add. They might only be willing to pay a value based on a 6 cap rate.

Note:

Cap rates are not the best metric to asses the quality of an assets returns. This is because so many factors can affect it. If one thing is going wrong and you can fix it, a cap rate may reflect a completely different return to what you can actually achieve. You must look at the financials and area to get an accurate picture of the deal's value.

Solutions

Account for how what you do in your business plan will affect the cap rate. This will be much more accurate than trying to blindly guess where cap rates will be. Even paying a couple thousand dollars a month to get co-star projections won't be able to predict the future. Nothing can.

Focus on the fundamentals. Choose a great market and neighborhood within it. One with good income and low crime. Choose assets that lie in your expertise of investing where you know that business model inside and out. Get long term fixed rate debt if you can.

Sitting on the sidelines and never doing a deal because you get caught up in not being able to predict the future guarantees a 0% return.