How To Select Future Cap Rates – Dr. Peter Linneman

What is the right cap rate to select for your sale valuation? Wharton Professor Emeritus Peter Linneman explains.

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 than the cap rate at which they purchased?

Dr. Peter Linneman:  No generally (they are exceptions), but generally you would expect the cap rate to be the same to higher.  The same is “the world doesn’’t change”: my propert’y doesn’t change in it’s competitive position, my liquidity doesn’’t change relative to today, and my interest rate environment that exists…nothing changes, is the same cap rate.  And there are times where — 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 really differ in six months?  If I am 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, let’’s say seven to ten years, generally you’’d believe that no matter how much capital expenditure you do and how well you maintain your building, your building slowly is not as competitive as it once was.  Slowly.  Somebody is going to build a new building, somebody is going to renovate a old building  in the market to bring it up.  And even though your building may not have changed, the other people are running a little faster, to the extent that your building isn’’t quite as competitive as it used to be, you’’re 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 rule of thumb where all it is reflecting is, as much as I might like, my building won’’t be quite 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 that’s 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 I’’ll give you a very simple example.  You go back to, after the Iron Curtain fell and the Soviet Bloc 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 Empire into part of western Europe, and as it became a part 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, there wi’ll be a better cap rate, a lower cap rate.  Now that’’s a risk you’’re taking if you are going to bet on that, but that was the most notable example that I’’ve seen in my life.  Interestingly as we sit here today, there’s kind of an opposite situation, which is you got ten year treasuries at historic lows, the lowest they’’ve been in 70 years, you’’ve got interest rates sitting there, and so people are saying: 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 know 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 over 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 time will tell if that was a good assumption or not.  You have to evaluate circumstances.  The starting point is: nothing changes, it’s the same exit and entrance.  And then you have to say, what do I think changes and why?  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 transaction’s performance off of a basis point.  Because if you are running a sensitivity table and your interval for your cap rate is 1%, then it’s kind of silly.  Right?

Dr. Peter Linneman:  Right.  You add to your sensitivity the equity if you’ve 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.  It’’s wiping out.  One thing I find a lot of people miss when they do cap rate sensitivity is, let’s say we are talking about if I should pay a 5 cap yield to start with, you say OK, I’ll go to a 4.5 cap, it’’s only 50 basis points, that’s nothing.  You go well wait wait wait, 50 basis points on 500 basis points, that’’s 10%, that’’s a huge percentage change that I’’m 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, it’’s a rounding error in terms of it.  If I went from a 20 cap to 19.5 cap, it’s 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, that’’s 10%.  So you got to be aware of your sensitivity is more about percentage changes in price than absolute number 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.  It’s 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 didn’t change it very much because it is starting out at this very potent temperature to begin with.

Dr. Peter Linneman:  Very well said.