What is a Reversion Cap Rate?
Accurate financial projections and risk management are essential for success. One crucial aspect of underwriting deals is the consideration of a reversion cap rate. This article aims to shed light on the concept of a reversion cap and its significance in real estate syndication, particularly focusing on the approach adopted by Fish Capital Investments.
What is Reversion Cap Rate?
Before delving into the reversion cap rate, it’s important to first grasp the concept of the entry market cap rate. This rate represents the market capitalization rate derived from other properties sold within a specific market. Fish Capital Investments uses entry cap rates to formulate projections for the potential increase in the property’s terminal value at the completion of a project.
We use reversion cap rates when assessing the exit value of a deal. We stress-test projected exit values by increasing the cap rate by a certain percentage, called a reversion cap. At Fish Capital Investments, the reversion cap rate is typically set 0.5% (or 50 basis points) higher than the entry market cap rate. For example, if the entry market cap rate is 6%, Fish Capital Investments would utilize a reversion cap rate of 6.5% to underwrite the deal’s exit sales value.
Significance of Reversion Cap Rates
The reversion cap rate is crucial as we run complex underwriting modeling to predict future value. It’s essential to use this reversion cap rate that lowers the projected exit value, which in return gives us a better indication of whether the projected return hurdles can ideally be met throughout the hold of the project. This process becomes a part of our sensitivity analysis.
By reducing the projected exit value, Fish Capital Investments can better understand whether the expected return targets can be realistically achieved throughout the investment’s duration.
Factors Influencing Reversion Cap Rate
While Fish Capital usually uses a 0.5% reversion cap rate, it varies by each deal. Several factors influence the determination of a property’s reversion cap rate. These factors include:
- Risk associated with the property.
- Debt and equity structure of the property.
- Time until the projected exit.
- Market and economic conditions at the projected exit time.
- Property type and geographic location.
Reversion Cap Rate Example
Let’s consider an example where the going-in market cap rate is 6%, and the reversion cap rate is set at 6.5%. Assuming an expected net operating income (NOI) of $600,000, the exit value can be calculated using the formula: NOI/Reversion Cap Rate.
Using the reversion cap rate of 6.5%, the exit value would be $600,000 / 0.065 = $9,230,769. In comparison, using the going-in market cap rate of 6%, the exit value would be $600,000 / 0.06 = $10,000,000. Thus, a 0.5% difference in cap rates results in a decrease in value of $769,231.
Fish Capital’s goal is to develop a project, whether new construction or value-add, that can withstand a rise in cap rate and the subsequent decline in value while still delivering excellent investor returns.
Ultimately, Fish Capital Investments aims to develop projects that can withstand potential market fluctuations and deliver excellent returns to investors. By incorporating the reversion cap rate in the underwriting process, we ensure a margin of safety and a higher probability of achieving investment success.