I've personally UW hundreds of deals using both Argus & Excel — some as small as $800K and others as big as $100M+

One of the most dangerous things a Multifamily Investor can do is model an exit cap rate lower than the going in cap rate

I mean come on. You can't go around assuming the whole macro economic environment of commercial real estate values will just bend to your will.

This is critical because say your property has a Forward-NOI (this is the 12 months immediately after the final year of your projected hold period) of $1M and you assume a 5.75% exit cap - $1M / 5.75%

You are saying you can sell your building for $17.4M at the end of your hold period.

Lets say you get overly-optimistic however and instead use a 4.75% exit cap. Now your model is assuming you get $21M when you sell. That one number can change the proceeds at sale by almost a $4M swing....yes this will unrealistically inflate your projected IRR.

Case Study

Check out the picture below that I just modeled real quick in excel. Notice that with every 100 bps of cap rate compression you get on the same NOI, your value increases quite exponentially.

It especially starts to take off as you approach 5% and below. That's why it was absolutely unprecedented when we saw low 4 caps and even sub 4 caps for Multifamily in many markets during the peak of the cycle in Covid. I think it could be decades before we see that again, but when it does you'll want to own lots of real estate at that point and be ready to sell some properties! Many of the groups who paid these cap rates for these deals are under water right now and struggling to keep their head above water. If they also bought them with floating rate debt, they have already drowned. 

Rule of thumb

Assume 5-10 bps of cap rate increase for every year of the hold period for safety. This gives you room in case cap rates actually expand and values drop further from where you bought the property. We currently syndicating a 160 unit property and we are buying it at a 6% in place cap rate. We are also underwriting a 6% exit cap rate, so not exactly following my rule of thumb but here is where we are justifying my own rule of thumb:

At a 6% exit cap rate, our exit sale price  is assumed to be $187K/per door. There are recent sale comps nearby in our submarket that have just transacted (present day) at $175K/door, $187K/door, and $195K/door. These are all built within the past 5 years just like our property, and we don't need to reach these valuations for 7 more years in order to hit our pro-forma. These properties do have better amenities and slightly nicer interiors so they should trade at a premium, but long story short we have 7 years to get to what comps are trading at per door today in our market. I truly think we will hit a 5.75% and possibly a 5.5% cap rate at exit, but that is the point of my post. I could be so off on that thinking so you typically shouldn't UW a lower exit cap than going in (unless you have a dang good reason and can back up your reasoning with strong data, even then it is a risk). 

You also really should be running a sensitivity on exit cap

It doesn't even have to be a fancy table if you don't know how to do that. Just watch your IRR while you toggle the exit cap in your model up and down. If you are at a 20% IRR at a 6 cap, but 15% at a 6.25% cap then that deal scares me a bit and I can discern that the returns are heavily driven by exit price.

• 25 bps is all it takes to take that deal from a great deal to an ok deal....
• 50 bps from great to quite mediocre...
• 75 bps from great to quite bad....
• 100 bps and it could be a catastrophic failure and waste of investors' time...maybe they even lose money
  
  

A deal like this doesn't seem to have a big margin of error.

Give yourself a buffer. Stress test the exit cap. Run the sensitivity.

One other consideration when determining what to model for your exit cap rate:

How long is your hold period and where do you estimate the cost of debt will be at that point in time?

If you bought a deal in 2021 and you are preparing to exit this year, you may need to modify your projections.

Did you model a 5 cap?

The cost of fixed, permanent debt has been around 5.5 - 6% for the last 1-2 years, so to achieve this you will have to convince a buyer to come in and purchase at negative leverage (yield aka cap rate < cost of debt) and that is very unrealistic unless your rents are under-market, there is a large loss to lease, or there is a mismanagement story and thus a clear picture of how to get to positive leverage fast.

Thanks for tuning in to my first ever MF Insiders blog post. Please leave me a like or comment if you found this valuable :)

Have a great week.