When looking at prospective real estate investments, you’ll likely see numerous terms that you may not be familiar with – especially if you are new to this type of investing. Just as those investing in stocks have unique phrases like “P/E ratio” and “dividend ex dates,” real estate investors have a set of terms and metrics to describe a prospective deal. One of the most common terms you’ll see is “cap rate.” While cap rates are essential when evaluating a real estate deal, a less-commonly known term, reversion cap rate, is equally important. Indeed, while the cap rate gives you insight into how profitable a deal could, in theory, be, the reversion cap rate gives you potential insight into how well the general partner has considered the possibility that the market may soften.
Sound intriguing? Here’s everything you need to know!
Cap Rates in Commercial Real Estate
To understand the meaning of the reversion cap rate, also referred to as an exit cap, it’s essential to first understand the meaning behind cap rates and how they are used in commercial real estate.
For reference, the cap rate is short for capitalization rate, and it effectively provides a metric of how long an investor will take to recoup their original money. The cap rate is calculated by NOI divided by the market value of the asset.
For example, if a $2 million real estate project has a year net operating income per year of $200,000, the capitalization rate is 10% ($200,000/ $2 million = 0.1 * 100% = 10%). Phrased differently, a 10% capitalization rate means that investors will take ten years to get their original money back.
Similarly, if the cap rate was 20%, it would take the investor five years.
Therefore, cap rates are like a yardstick that measures the value of a project. Higher risk typically requires a higher reward, which is a higher cap rate. Lower risk means a lower cap rate but the income and property values are, hopefully, more stable.
Reversion Cap Rate: What Is It?
The reversion cap rate is the projected cap rate at the end of the project. It is also referred to as an exit cap rate or the terminal cap rate. That is, it’s a measure of the cap rate at the exit or sale of the property rather than the rate at the start of the investment. The expected net operating income (NOI) per year is divided by the reversion cap rate (expressed as a percentage) to get the property value at the end of projects hold time.
Why Is The Reversion Cap Rate Metric Important?
Superficially, it would seem as though the cap rate was the primary metric to focus on – after all, isn’t the critical number what you’ll earn throughout the project instead of what the “final” rate will be?
The reversion cap rate can reveal important clues about how well-thought-out the investment opportunity is.
In particular, you’ll want to look for a reversion cap rate at a minimum 0.5% higher than the entry cap rate of the project.
At first, this might sound strange – a higher cap rate is usually better, but why is it an indicator of how good the deal is overall?
The reason is quite simple: a higher cap rate at the end of the investment means that the general partners on the deal consider the possibility that the market may take a dip at the end of the investment hold period and are projecting a conservative sale price on the project. It also means all the underwriting, financing, and timelines assume that the market may go down.
An Example Of The Reversion Cap
Consider the following example. Let’s say that you have a syndication that projects an NOI of $50,000 per year on a $500,000 investment. That is a capitalization rate of 10%. They say the cap rate will be 10.5% at the end of the five-year term, a complete 0.5% higher in this simple example. That means the final selling price will be $476,190 ($50,000 / 0.5% = $476,190). This projection is conservative as it predicts that the asset will sell at a lower value than its purchase price.
And that’s why the reversion cap metric is so essential: sometimes real estate syndicators can “mask” bad returns with an overly optimistic selling price. Let’s say, for example, another project returns the same NOI of $50,000 per year on a $500k investment. That’s a cap rate of 10%. But, if they say the property will sell for double what it is now, that winds up being a reversion cap rate of 5% ($50,000 / $1 million = 0.05 * 100% = 5%).
What an outstanding investment, you might think, since the lower cap rate means the property is more stable and will be easier to sell! The problem is that the entire project banks on selling the property at a considerable price increase. Nobody is that clairvoyant when it comes to real estate!
Conservative Underwriting Is What You Want to See In Commercial Real Estate
Ultimately, the more conservative (but realistic) the estimates are, the more confidence you can have in the project and your real estate syndication company that is putting the deal together. If someone promises that big payoff upon selling the property or unrealistic cash-on-cash returns during the investment duration, you should treat the investment with healthy skepticism. That can be a warning sign that the general partners are not entirely forthcoming with the potential risks.
Since the general partner will lead the project, it’s crucial that you can trust them and that this person has the knowledge necessary to execute the project successfully. If they don’t, you could find yourself out quite a bit of money on a bad investment.
That’s why metrics like reversion cap rate are so important: they are little things that help prospective investors separate the well-structured investments that have the highest probability of success from the idealistic ones that may run into issues.
Reversion Cap Rate: A Recap
To recap, the reversion cap rate is the cap rate at the end of the real estate project, not the cap rate going into the project. Investors should look for a reversion cap rate that is higher than the going-in rate because that shows that the underwriting and all projections assume the possibility that the market may soften.
You can calculate the expected selling price by taking the final year’s net operating income and dividing it by the reversion cap rate. That will give you the final expected value of the property.
This metric, along with many others, helps prospective investors determine which real estate deals are worth the time and effort. Before investing any money, please always remember that all investment carries the risk of loss. However, the more you know about these deals and their deal structures, the better chance you have of finding the best syndication for your financial objectives!