Exit Ramp

What does every institutional investor who invested in commercial real estate from 2011 to 2015 have in common? They all were wrong on their assumption of higher exit cap rates. Cap rates actually decreased for all major asset types, except for some retail categories.

The industry convention on exit cap rates is well known: Add 50 to 100 basis points on your exit to account for a rising interest rate environment down the road. Fundamental issues can influence these assumptions with a higher delta between going-in and exit cap rates for value add vs. core assets. There also is some variability by market as supply-laden markets have consistently higher exit cap rate assumptions than supply-constrained markets. Nevertheless, the default strategy for like-minded institutional investors is to add a lot to the exit cap rate. 

This is backed up by data on hundreds of recent transactions underwritten by CBRE’s Financial Consulting Group:

The industry convention for exit cap rates has been wrong over the past eight years and many would argue that it’s always wrong during the upswing of an economic cycle. And I would argue that it will continue to be wrong indefinitely, even during the next downturn. Inflation, which drives up interest rates, will remain low because of a combination of too much cheap money, cheap labor, cheap energy and innovation. In his book “The Age of Oversupply,” investment banker Daniel Alpert argues that we are in for a period of permanent deflation. CBRE’s econometric forecasting gurus must have read this book (or got tired of my pestering them!) and we now have one of the most conservative calls on Wall Street with the 10-year Treasury topping out at around 2.9%.    

Cap rates have too much impact on our underwriting and, candidly, the returns we earn. Those who make internal rate of return investments expect to make all their money upon exit, not on income. But I want my value as a real estate professional to be judged on my asset management acumen and not the Russian Roulette of hoping the capital markets will bail me out at the appropriate time. That’s wishful thinking as it is not where most of the value in our industry is reaped; it is by cap rate compression on the exit.

Given that adding 50 to 100 bps on the exit cap is a bedrock underwriting practice, the market isn’t going to move on a dime. We need a strategy on exit cap rates that is acceptable to the powers that be, who are not the Wall Street masters of the universe, the foreign capital behemoths or the 25-year-old with a Bloomberg terminal who has it all figured out. The power is in the hands of the appraiser sitting in a cube in Fresno whose MAI status depends on complying with industry-accepted underwriting principles.

The evidence that changing exit-cap methodology is correct in the face of changing inflation assumptions is seen by comparing the cap rates for prime assets in prime markets globally. The going-in cap rates are largely equal in global prime markets, though the EU prime cap rates are consistently 50 to 100 bps lower than U.S. cap rates for similar assets. This is because of lower inflation assumptions in the EU. I’d argue that this deflationary environment is now impacting the U.S., will accelerate and why we too should continue to make our cap rate assumptions more aggressive.    

Lower inflation means lower cap rates. Lead by lowering your exit cap rate assumptions. 

By Spencer Levy, Chairman & Senior Economic Advisor, Americas Research, CBRE.