Estimating Terminal Cap Rates

[hastalavista]

I just finished the Advanced Income Capitalization class given by the AI (Don't know my test results yet!). During one of the topics, we were discussing terminal cap rates, and a generalization seemed to appear that indicated the terminal cap rates were anywhere from 50- to 150-basis points above the going-in cap rate.

Along with this discussion was an observation that current cap rates may be increasing (again, this is a very general statement and different markets or property-types can react differently).

My question is this: If uncertainty is increasing, is anyone increasing their spread in forecasting the terminal cap rate?

I ask this because my follow-up question is this: If there is a typical/historical relationship between going-in and terminal cap rates, and one is forecasting a greater-than-typical spread, would it not be appropriate to re-analyze the going-in cap-rate and perhaps consider that the terminal cap rate is appropriate but the going-in rate may be too low?

I appreciate all viewpoints! :new_smile-l:

 

[Howard Klahr]

Didn't you get your cap rate and discount rate dice as part of your course materials? How elese are you expected to perform accurate forecasts.

 

[hastalavista]

Didn't you get your cap rate and discount rate dice as part of your course materials? How elese are you expected to perform accurate forecasts.

I got them. But after throwing them for a while I began to suspect they were loaded! :laugh:

 

[PL1957]

My two cents ...

When you go beyond the "real" numbers that get you an OAR, you begin dealing with investor expectations. Mathematical formulas or rules of thumb can provide a veneer of sophistication in explaining where you pull the IRR and Terminal Rate from, but they lack any real substance.

The old rules used to be that the Teriminal Rate was 50-100 bp above the going-in rate and the IRR was equal to the going-in rate plus the compound annual growth rate in income over the holding period. If you looked at Korpacz on a historic basis, you'd see this held up pretty well until the last couple of years. All that went out the window over the last several years as investors became more aggresive in how they looked at properties. The explanation given was that the aggressiveness was needed due to the limited supply of desirable properties and the huge amount of capital that was pursuing them. "Rational" investment parameters that mirrored historic trends would leave buyers sitting on the sidelines as they lost property after property to other buyers.

Investor expectations can only be determined by talking to investors - either directly, or indirectly by refering to various investor surveys. The returns that investors actually attain are really irrelevant. It's their expectations that they base buy decisions on. It will be really interesting to see what happens over the next six months or so because EVERYONE has been saying cap rates and discount rates will be moving up. The only problem is that there's not a lot of evidence out there that it's actually happening.

 

[Caligirl]

The rate is always 10% (did you get the correct set of dice). :new_smile-l:

Generally (at least in my limited experience) the spread should reflect changes in the property, need for capital improvements, etc, over the term of ownership. The new going-in rate will reflect the buyer's perception of those issues ie., the market's reaction. Ideally the relationship between the rates should be a snapshot of both the property itself and the market. However as PL pointed out, rational investing isn't always the rule.

 

[Stephen J. Vertin MAI]

I ask this because my follow-up question is this: If there is a typical/historical relationship between going-in and terminal cap rates, and one is forecasting a greater-than-typical spread, would it not be appropriate to re-analyze the going-in cap-rate and perhaps consider that the terminal cap rate is appropriate but the going-in rate may be too low?

The spread is basically the analysis of two time frames. Short and long term. The short term analysis is direct rates experienced in the current market and the second is an analysis of rates sometime in the future. Long term rates are typical greater than short term simply due to projected risk unless there is an inverse yield curve (which has happened in the past but these are relatively uncommon). Further the expectation, at least in theory, is the asset will have depreciated (older improvements, higher maintenance cost and most likely other cost as properties become more energy efficient). Thus a higher terminal rate than a going in rate. I personally do not believe it correct methodology to determine a terminal rate and back into a going in rate. People cannot even predict the weather one week out let alone risk rates of return. The greater spread is simply a projection the asset has more overall future risk. Not the other way around.

All that went out the window over the last several years as investors became more aggressive in how they looked at properties. The explanation given was that the aggressiveness was needed due to the limited supply of desirable properties and the huge amount of capital that was pursuing them. "Rational" investment parameters that mirrored historic trends would leave buyers sitting on the sidelines as they lost property after property to other buyers.

While everything you have said is true, it is my personal opinion, these actions were the proverbial canary in the coal mind. When rational investment parameters leave buyers sitting maybe it is time to be sitting. They were buying when everyone was buying and now selling when everyone is trying to sell. As a general rule I have seen commercial value escalations come to a crawl in most property types. Especially in the Michigan markets (which I am working in more and more). While the causes could be debated I think the fundamental principles of sound investing should never be ignored. Of course this is from an investors stand point and has little to do with appraising. Our job is to simply reflect the market, even when markets are irrational. However, I do believe it is part of my job to point out these shifts in thinking.

 

[Fred]

In DCF, there is a seventh function of a dollar. It's the fear factor. (I used to call it the Pee Wee factor, but the guys I was working kept thinking I said PV factor).



Look at the effect of applying two fractional factors to the same amount.

Big Effect - Short term, "high" load: Five years and 100 basis points. Push the Rn up from 9% to 10% and that reduces reversion value by about 9.8%. Then hit that 9.8% value change with the five-year factor for a Yo of 11%. That 0.098 x 0.58 = .05.​

Small Effect - Long term, "low" load - Fifteen years and 50 basis points. Push the Rn up from 9% to 9.5% and that reduces reversion value by about 5.5%. Then hit that 5.5% value change with the fifteen-year factor for a Yo of 11%. That 0.055 x 0.2 = .01.​

So as a generalized statement, loading the terminal cap rate changes model value by 1%-5%. In lieu of such "rules" (PL's term), you can keep Rn equal to Ro and always round your DCF down. Over the course of a career, this will have same net effect as playing with (excuse me, loading) the Rn.

I believe there is another fear factor. In my experience which is now three years old, the AI still teaches appraisers to reduce value by broker's commission in DCF. We don't do that in direct cap or sales comparison. My theory is that there is a subconcious perception that low DCF value generates less liability.

 

[Curtis West]

I ask this because my follow-up question is this: If there is a typical/historical relationship between going-in and terminal cap rates, and one is forecasting a greater-than-typical spread, would it not be appropriate to re-analyze the going-in cap-rate and perhaps consider that the terminal cap rate is appropriate but the going-in rate may be too low?

I appreciate all viewpoints! :new_smile-l:

In my opinion it would be more appropriate to recognize that you have determined the going-in cap rate by analysis of reasonably available pertinent data and that the your forecast of a terminal cap rate is based on an assumption of (unknown, uncertain) future events. I would also avoid generalizations about terminal cap rate being higher than the going-in rate.

 

[Caligirl]

I would also avoid generalizations about terminal cap rate being higher than the going-in rate.

Very true that each case is unique and depends on the market and individual properties.

 

[hastalavista]

Thanks for everyone's response.

To give the instructor credit, when I asked this question in the class, he said that it would be dangerous to draw any type of historical inference about a relationship between going-in and terminal cap rates. He also said I'd be much better off focusing on the first three years of data for the DCF vs. the 7th or 10th year Rn. :new_smile-l:

I found in this particular class, being a non-commercial/residential-only appraiser, I probably asked questions for which everyone else understood the answers to be axiomatic.

(Hey, I wanted to get my money's worth!)