Exit cap 15 basis points above entry, five year hold. Which line do you break first?

Question

I've been reading two offering models side by side for a week and the thing that keeps stopping me is the terminal value.

Deal one: 200 units, entry cap 5.1, exit cap 5.25 at the end of year five, rent growth 3.5% in years one and two after renovation, expense growth 3%. Deal two on a similar vintage asset: entry 5.3, exit 6.0, rent growth 2.5% flat, expense growth 4%. Deal two's projected IRR is lower by about four points, and the sponsor says that's on purpose.

So when I sit down with a sponsor and get one hour, I don't know which assumption to spend it on. The argument for going straight at the exit cap is that terminal value is most of the return in a five year equity deal, and 75 basis points of cap expansion can eat the whole promote and part of my principal. The argument against is that the exit cap is a guess about a year nobody can see, and every sponsor knows to expect that question, so you learn nothing. The lines you can actually check are the ones about today: what rents the last renovated units achieved, what the tax bill did after the last reassessment in that state, what payroll and insurance actually ran per unit last year. Break the operating assumptions and the exit cap stops mattering because you never get to it.

Both sound right to me depending on the hour of the day. Where do you actually push first, and what does the answer tell you that the model doesn't?

luis_carrera · Answer

I built the grid for this because I couldn't stop myself. Held everything else and moved exit cap alone on a five year multifamily model at 65% leverage. 50bps of expansion took roughly 4 to 5 points off IRR and about 0.15 off equity multiple. Then I held cap flat and cut rent growth from 3.5% to 1.5%, which cost me less on IRR but it also lowered NOI at exit, which lowered the sale price, so it hit twice.

That double hit is why I stopped treating them as separate questions. Rent growth is an input to the exit price, so a sponsor who is optimistic on rents and tight on the exit cap is stacking the same bet twice. I still push the operating lines first, juniper, because a sponsor can say "we underwrote 50bps of expansion" and it costs them nothing, but they can't invent last year's insurance renewal.

tylerbrooks9 · Answer

Exit cap first, every time. I want to know if the deal survives a bad exit before I care how good the good exit is.

ehernandez74 · Answer

Wrong slot for me maybe but I'll say it anyway. Expenses. I run eleven units and the line that has moved on me is insurance, then taxes after a sale triggered reassessment, and both are local. A sponsor underwriting 3% expense growth in a market where insurance has been renewing far above that is telling me they haven't paid a bill there recently. Ask which of their existing properties is in the same county and what its actual operating statement did over the last two years.

laurenkim53 · Answer

The question I'd ask before any of them is who decides when the exit happens. The exit cap in the model is attached to a specific month in year five. If the operating agreement lets the sponsor extend the hold twice for a year each at their discretion, then the exit cap assumption is a mood, and the real number is whatever the market gives them the week they choose to sell. I'd want to see the extension language and whether extending requires any LP vote before I argued about basis points. windlass, does your grid do anything with hold length, or is five years fixed in it?

paulgrant17 · Answer

Everything above assumes the exit cap is knowable within a range, which works in a market with twenty comparable trades a year. In the small markets I look at there might be three trades and one of them was a family transfer. Also sale prices aren't public in a fair number of states, so the "comps" a sponsor shows you can be broker reported and unverifiable. When I can't test the exit cap I stop trying and put the whole hour on debt, because loan maturity is a date on a document rather than an opinion.

karen_whitfield · Answer

The check I'd want is on the sponsor's own history. What cap rate did they actually exit their last three full cycle deals at, and what had they underwritten at acquisition? If they underwrote 5.5 and got 5.4 in a strong market, that tells me little. If they underwrote 5.5 and got 6.2 and still returned capital, I'd rather have that person. Nobody publishes that comparison, so you have to ask for it plainly and see whether the answer arrives.

Exit cap 15 basis points above entry, five year hold. Which line do you break first?

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