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Cap rate compression trap

Happy Wednesday! 👋

I know what you’re thinking - “how hard can it be to check for cap rate compression!”

If the going in cap rate is 6% and the exit cap rate is 6%, I should be fine.. right?

Today we’ll deep dive on cap rate compression assumptions and why this statement is wrong.

Let’s first understand what cap rate compression is:

• Cap rate = Net Operating Income (NOI) / Price.

• As cap rates fall, the value of the property rises, making it seem like a good investment even if nothing about the property itself has improved.

• If you want to familiarize yourself with cap rates a big more, I’d recommend reading 4 reasons why cap rates are misleading.

• Cap rate compression refers to a decrease in a cap rate over the hold period of an investment

• In English, this means that the GP expects the property (via supply/demand factors) to be worth more ~regardless of what the NOI is at the property

• Note that in the vast majority of cases cap rates are not within the GPs control and are simply a macro factor that needs to be considered when doing diligence on an investment.

I advise LPs on deals full time and when I give feedback on deals with cap rate compression, I always tell the LP “there’s nothing wrong with investing in a cap rate compression deal as long as:

• You know that there is a cap rate compression assumption in the deal (you’d be surprised how many LPs don’t know and assume the GP would tell them)

• You understand its implications on your returns, and

• You understand that you’re (indirectly) investing into a macro thesis rather than a pure real estate play

It goes without saying that a cap rate needs to be assumed for an exit - otherwise you can’t calculate an IRR! However, from a risk perspective, there’s a big difference between a 2x projected multiple with cap rate compression and a 2x without.

There’s a big difference between a 2x projected multiple with cap rate compression and a 2x without

So if cap rate compressions are outside the control of the GP, why would they assume them?

Because the returns will look great!

Take a look at the below table (see why most LP investments won’t 2x your money for the full article & assumptions).

If you start at the 11% square and move up to where the green is, you’ll see that lowering your exit cap rate by 1% (100 bps - from 6% to 5%) moves the IRR you present to investors from 11% to 20%.

Now, let’s run through some examples because I want to illustrate two separate points:

Example 1: Cap Rate Compression Saving a Poorly Operated Deal

• The Deal: A GP acquires a multifamily property at a market cap rate of 6% with $100,000 in NOI equating to a purchase price of $1.66MM.

• Operational Failures: The GP struggles with management, and expenses rise due to maintenance and operational inefficiencies. NOI drops to $75,000, in part due to vacancy, increased costs, and delinquency issues.

• Cap Rate Compression: External market factors cause cap rates in the area to drop from 6% to 4%.

• Sale: The GP sells the property for $75,000/4% = $1.88MM and, ignoring fees, records a 1.66x = (1.88-1.66*.8)/(1.66*.2) multiple at the deal level assuming the original acquisition had 80% leverage.

• The Lesson: While LPs received a return and there’s reason to celebrate on both sides, it’s important to understand that the returns weren’t a result of the the GP’s efforts.

• The reliance on cap rate compression masked the GP’s poor operational performance, which is certainly something you’d like to know about a GP’s track record (see more in #2 of Track Record Audit)

Example 2: How Overpaying for a Property Can Make Cap Rate Compression Misleading

• Deal: A GP purchases a property at a 4.5% cap rate, but the true market cap rate for similar assets is closer to 5.5%.

• Perception: On paper, the GP presents the deal with a projected exit cap rate of 4.75%, which seems reasonable compared to the 4.5% going-in cap rate. In fact, it might even seem conservative - it has cap rate expansion one might conclude!

• Reality: The 4.75% exit has 75 bps of cap rate compression embedded in it, since the market rate cap rate was actually 5.5%.

• Lesson: Overpaying for a property at an artificially low cap rate relative to market might conceal a cap rate compression (on top of the overall risk of overpaying).

So, you might (rightfully) ask - great, but how do I figure out if the GP is overpaying?

The answer to this is doing a lot of due diligence on market comps - I will write on that more in the future. For now I’ll just say that you certainly shouldn’t invest in a property where a proper comp set wasn’t shared with you.

If you still have energy to read more, I would also recommend reading more about the cap rate compression’s cousin - the refinance assumption trap.

I advise LPs on existing and potential positions and write articles here weekly on what I see in the marketplace that could help you invest better. You can find me on LinkedIn or Twitter.

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