Cap rate discussions can become confusing when people start to discuss “spreads” — Wharton Emeritus Professor Peter Linneman makes it all crystal clear.
Full interview transcript:
Bruce Kirsch: When purchasers acquire a property, the cap rate at which they acquire is simply a mathematical calculation once the transaction is done. But when they make projections and look forward into some sale year in the future, in order to complete the proforma analysis they need to assign some future cap rate at which they anticipate they will be able to sell. And naturally the lower the cap rate the more valuable the asset. Is it realistic for property owners to forecast a lower cap rate then the cap rate at which they purchased?
Dr. Peter Linneman: No generally theyre exceptions but generally you would expect the cap rate should be the same to higher. The same is the world doesnt change, my property doesnt change in its competitive position, my liquidity doesnt change relative to today, and my interest rate environment that exists. Nothing changes, is the same cap rate. And there are times when by the way you are going to sell 6 months later, maybe believing you are going to sell at the same cap rate is a good thing because how much do you think the world is going to change in six months? If I am just going to plan to sell in ten years, the world could be a lot different in a lot of ways; interest rates could be different, the competitive environment could be different, my property could be different.
Generally, if you anticipate holding for a reasonably long period, lets say seven to ten years, generally youd believe that no matter how much capital expenditure you do and how well you maintain your building, your building is slowly not as competitive as it once was. Slowly. Somebodies going to build a new building, somebodies going to renovate a old building I the market to bring it up. Even though your building may not have changed, the other people are running a little faster, to the extent that your building isnt as quite competitive as it used to be, youre going to have to give people more income for the same price, that is your cap rate will go up. As a general matter you should anticipate your exit cap rate, on a 7-10 year hold, being somewhat higher than your purchase cap rate. And you can always come up with exceptions but that is a general thumb where all it is reflecting is, as much as I might like, my building wont be as competitive in 10 years as it is today.
Bruce Kirsch: Right. Now there is a potential situation where while your property does age and become relatively less attractive to new stock or renovated stock thats brought into the market, if as a trend in your submarket cap rates are compressing on a net basis, they could end up being a wash. Right?
Dr. Peter Linneman: It could be more than a wash and Ill give you a very simple example. You go back to, after the iron curtain fell and the Soviet block collapsed, and people would be buying in Poland at cap rates of 10, 11, 12, 13, and even though they knew their buildings probably be eroding and their competitive position within the market over the next decade, the general belief is Poland was going to integrate from being part of the old Soviet Union Empire into western Europe and as it became apart of western Europe, its risk would diminish. Its liquidity would increase and therefore there was a belief in the secular decline in cap rates.
Namely since I am not dragging you to the Soviet Union, since I am not dragging you to a non-liquid market 10 years from now, theyll be a better cap rate, a lower cap rate. Now thats a risk youre taking if you are going to be on that but that was the most notable example that Ive seen in my life. Interestingly as we sit here today, this kind of an opposite situation is you got ten year treasuries at historic lows, the lowest theyve been in 70 years, youve got interest rates sitting there, so people are saying that. Yeah if interest rates stay at where they are at, ten year treasury at basically 2% or less, the cap rate should be 5% but do I really believe that 10 years from now that the ten year treasury will still be 1.7%? And you got a lot of people, nobody is going to for 10 years what the answer is.
You got a lot of people saying that there is too big a chance the interest rates rise, having nothing to do with me for the next ten years, so I am going to put the cap rate in 50-100 basis points higher for my exit then my entrance as a cushion. Only tie will tell if that was a good assumption or not. You have to evaluate circumstances. The starting point is nothing changes, then its the same exit and entrance. And the have to say, what do I think changes? And that is what you are relying on.
Bruce Kirsch: Right. I think it is important that students run these numbers just for their own edification at different cap rates to really come to appreciate the sensitivity of a transactions performance off of a basis point. Because if you are running a sensitivity table and your interval for your cap rate is 1%, then its kind of silly. Right?
Dr. Peter Linneman: Right. You add to your sensitivity the equity if you leveraged. The power of leverage is, if the cap rate moves for you, that is, it falls from when you buy. You do spectacular but it is just as punishing in reverse. Its wiping out. One thing I find a lot of people miss when they do cap rate sensitivity is, lets say we are talking about if I should pay a 5 cap to start with, you say ok ok, Ill go to a 4.5 cap, its only 50 basis points, that’s nothing. You go well wait wait wait, 50 basis points on 500 basis points, thats 10%, thats a huge percentage change that Im talking about. Huge.
So you have to think about them as a percentage change matter. If I went from 5 to 4.99, to your point, its a rounding error in terms of it. If I went from a 20 cap to 19.5 cap, it a kind of rounding error. But if I go 50 basis points, the same 50 basis points, from a 5 to a 4.5 cap, thats 10%. So you got to be aware of your sensitivity is more about percentage changes in price than absolute numbers of basis points. You just have to always focus on that. Especially when cap rates get very low, people sometimes lose sight of the fact, saying that’s only 10-20 basis points. 10-20 basis points is nothing if you are talking about very high cap rates but it is a big percent when you are talking about low cap rates.
Bruce Kirsch: Right. Its kind of like a faucet that is very sensitive. If the water is really hot, making it slightly hotter, then you have to pull your hand away even though you didnt change it very much because it is starting out at this very potent temperature to begin with.
Dr. Peter Linneman: Very well said.