Prospective real estate investments may comprise various unfamiliar terms. ‘Cap Rate’ is another common market term used to evaluate a real estate deal. On the other hand, reversion cap rates offer insights considered by the general partner.
There are more details on how this rate is a powerful tool for underwriting exit sales value. This article talks about cap rates in the commercial market, followed by the importance of the reversion cap rate metric.
Understanding Cap Rates
Before directly talking about reversion cap rate, it is vital to understand the meaning of cap rates in the commercial market. Capitalization rate determines how long an investor will take to regain the original money.
The calculation is done by dividing the net operating income ( NOI ) by the asset’s market value. If the rate is about 10%, the investor will take about ten years to regain the original money. This rate is meant to measure the project’s value. Higher risk indicates a higher reward because the cap rate is also high. However, lower rates indicate lower risks, stable property value, and income.
What is Reversion Cap Rate?
It is the project cap rate measured for the end. Meaning it’s a cap value for the sale of a property rather than the starting of the investment. Many investors consider using the exit cap rates to determine the resale value of a property.
Using Exit Cap Rate to Evaluate Resale Price
The simple income capitalization formula is used to calculate the resale price of a property toward the end of the investment stage. The formula is –
Resale price (n) = NOI / Terminal Capitalization Rate
The estimated resale price plays a crucial role in evaluating total returns. Using a low terminal cap rate sometimes leads to overestimation. Henceforth, investors need to be very careful. Due to overestimation, a mediocre property can seem attractive.
Why is Exit Cap Rate Important?
It would generally seem that the cap value is an essential metric to focus entirely on. However, do you think knowing the final rates is crucial rather than learning about the earnings through the course? The exit cap reveals a complete evaluation of how thoughtful the investment is. A higher rate is generally better, but how does it indicate the goodness of a particular deal?
A higher exit value toward the investment’s end suggests that the general partners foresee a dip at the end. Also, they are estimating a conservative price of the project. It also indicates that the underwriting and financing segments also forecast a drop. The exit cap rate is essential because sometimes the syndicators mask a terrible return with a lucrative selling offer.
If the estimates are conservative, one can have more confidence in the project. If you find someone pays a big pay-off during the property selling, take it as a warning sign. It might indicate underlying risks that the general partners are not highlighting.
This is why the reversion cap metric is vital. It helps investors separate structured investments from the ones that might have issues. For more details, you can connect with an investment specialist.
However, investors must be cautious and reasonable while estimating the resale value using the exit cap. Considering the market cap value during acquisition, other market dynamics, and the market stage cycle is crucial.