What’s Your Terminal Cap Rate Assumption?

What’s Your Terminal Cap Rate Assumption?

Don’t repeat the same mistake that investors make in up and down markets.

Commercial real estate investors (speculators) bet on the come –- that the next investor will pay a lower cap rate — and as cap rates decompress, or increase, values decline and investors who base their projections on a lower terminal or exit cap rate, will be caught holding the hot potato.

As you acquire commercial property in this market, pay attention to your fundamentals. 

Cash flow performance makes up a large part of your return on investment, while those who are betting that the next investor will pay a lower cap rate than you did should be careful, it may not happen.

Institutional investors are focused on performing cap rates today.

In the past, they projected 3-5 year holding periods. Now they’re looking at 5-8 or even 10 years.  And instead of counting on a lower cap rate to boost their internal rate of returns today, they’re planning on cap rates increasing as much as 75 basis points.

They believe:

  1. Interest rates will increase during their holding period;
  2. Annual operating fundamentals and cash flow performance are paramount;
  3. Properties should support leverage and be sustainable through market fluctuations over a longer holding period.

Be careful. If you’re making promises or acquisition decisions on an uncertain future, it makes sense to be safe rather than sorry.

The worst that can happen is that you hit your numbers, and if we’re all wrong and cap rates continue to decrease, you’ll just make that much more money.

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