SS76: What is a Cap Rate and What is a Reversion Cap Rate?

The capitalization rate is an important metric in the world of commercial real estate. In this episode, Charles discusses what the cap rate is and what the reversion cap rate is and why are properties advertised and sold chiefly with their cap rate and not another metric like cash-on-cash return.

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Talking Points:

If you have ever looked at any commercial real estate investment or offering you will see a cap rate listed. What is the cap rate?
The capitalization rate indicates the rate of return that is expected to be generated on a commercial real estate asset. The measure utilizes the net income of the property and the property’s value. When you divide the net income by the property’s value; you are given a percentage that estimates the investor’s potential return on this particular investment.
Cap rate; described a different way, is the cash-on-return a property will produce if it is purchased in all cash. You purchase a property for $100k and it generates $5,000 per year in net operating income; it has a 5% capitalization rate (a 5 cap). If you paid cash for the property; it would also have a 5% cash-on-cash return as well.
The cap rate is helpful in quickly determining the value of similar properties in a particular market. It should not be used as the primary deciding factor on purchasing a property since it does not usually take into account leverage, future cash flows, deferred maintenance, improvements, etc.
A HIGH CAP RATE DOES NOT MEAN IT IS A BETTER INVESTMENT OR PROPERTY. Typically, the best properties, in the best areas and in the best markets will have the lowest cap rates. Don’t get caught buying a property because it has a high cap rate then realize later on that you just purchased a property in an area that is not growing or worse yet, a war zone.
The cap rate is a measure of risk. Lower the cap rate; lower the risk. Higher cap rate properties have a higher risk.
Now, that you know what a cap rate is; what is a reversion cap rate?
The reversion cap rate is the projected cap rate at the end of the project. It is normally called the exit cap by commercial real estate investors. It is a measure of the cap rate at the sale of the property.
Typically, you want to see an exit cap rate that is 1/2% higher than the cap rate at the time of purchase. We will increase the cap rate by .1%-.2% each year we plan to own it. This is conservative. If we plan to own it for 5 years; we will increase the exit cap rate by .50%-1%; depending on where we feel the market will be at the time of sale. If the general consensus is that the market will soften; we will increase the cap rate even higher.
The higher the reversion cap rate; the more conservative the underwriting.

Whenever you are reviewing underwriting; make sure to always review the exit cap rate. If it is not increasing by at least .1% per year; consider it a red flag. If the cap rate on purchase is the same as the cap rate at exit; they are saying that nothing will change in the market over the hold period; interest rates will stay the same, lending programs will not change and demand will continue as it did in the past. There is however no way of knowing what the future holds; this is the reasoning behind a higher exit cap rate.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is a cap rate and what is a reversion cap rate. If you’ve ever looked at any commercial real estate investment or offering, you’ll see a cap rate listed, but what is a cap rate? Well, the capitalization rate indicates the rate of return. That’s expected to be generated on a commercial real estate asset. The measure utilizes the net income of the property and the property’s value. When you divide the net income by the property’s value, you were given a percentage that estimates the investor’s potential return on this particular investment cap rate. Describe the different way is the cash on cash return. A property will produce if it is purchased in all cash, you purchase a property for a hundred thousand dollars and it generates $5,000 per year in net operating income. It has a 5% capitalization rate, or it’s a five cap.

Charles:
If you paid cash for the property, it would also have a 5% cash on cash return. The cap rate is helpful in quickly determining the value of similar properties in the particular market. It should not be used as the primary deciding factor on purchasing a property since it does not usually take into account leverage, future cash flows, deferred maintenance improvements, et cetera. A high cap rate does not mean it’s a better investment or property. Typically the best properties and the best areas in the best markets will have the lowest cap rates don’t get caught buying a property because it has a high cap rate. Then realize later on that you just purchased property in an area that’s not growing or worse yet a war zone. The cap rate is measured of risk. The lower the cap rate, the lower, the risk higher cap rate properties have higher risk.

Charles:
Now that you know what a cap is, what is a reversion cap rate? Well, the reversion cap rate is a projected cap rate. At the end of a project. It is normally called the exit cap by commercial real estate investors. It is a measure of the cap rate at the sale of the property. Typically you’ll want to see an exit cap rate that is a half percent higher than the cap rate. At the time of purchase, we will increase the cap rate by 0.1 or 10 basis points to 0.2% each year or 20 basis points. We plan to own it. This is conservative. If we plan to own it for five years, we will increase the exit cap rate by a half percent to 1%, depending on where we feel the market will be at the time of sale. If the general consensus is that the market will soften will increase the cap rate, even higher, the higher the reversion cap rate, the more conservative the underwriting, whenever you’re reviewing underwriting, make sure to always review the exit cap rate.

Charles:
If it is not increasing by at least 0.1% per year considerate a red flag. The cap on purchase is the same as the cap on exit. They’re saying that nothing will change in the market over the whole period. Interest rates will stay the same lending programs will not change and demand will continue as it has in the past. There is however, no way of knowing what the future holds. This is the reason behind a higher exit cap rate. So I hope you enjoyed. Please remember to rate review, subscribe, submit comments, and potential show topics at global investors, podcast.com. Look forward to two more episodes next week. See you then

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