If you are new to real estate investing, you may not even be aware of many phrases related to real estate investment. Real estate investors have a set of terminologies and metrics to define a potential acquisition, just as stock investors have specific terms like “P/E ratio” and “dividend ex dates.”
“Cap Rate” is one of the phrases you’ll hear most frequently. While this rate is crucial when assessing a real estate acquisition, the less well-known concept of reversion real estate cap rate is just as significant.
The reversion cap rate offers prospective insights into how much the general partner had considered the risk that the market may weaken. In contrast, the cap rate provides information on how profitable a deal may theoretically be.
Commercial Real Estate Cap Rates
It’s crucial to comprehend the concept of cap rates and how well they are applied in commercial property before understanding the reversion cap rate. For reference, the capitalization rate measures how long an investor will take to recover their initial investment. It is calculated by dividing NOI by the asset’s market value.
The capitalization rate, for instance, is 10% if a $2 million estate project has a $200,000 net operating revenue per year ($200,000/$2 million = 0.1 * 100% = 10%). To put it another way, a capitalization rate of 10% indicates that it will take investors ten years to recover their initial investment. Similarly, the investor would take five years if the rate was 20 percent.
Therefore, cap rates are a yardstick to gauge a project’s worth. A higher reward, or rate, is often necessary for a higher risk—lower risk results in a lower cap rate but presumably more consistent income and property prices.
What Is a Reversion Cap Rate?
The anticipated cap rate for the project’s conclusion is the reversion cap rate. It is also known as the terminal or exit cap rate. It is measured at closing rather than at the start of the transaction. After the project’s hold time, the property value is calculated by the projected net operating income each year by the reversion real estate cap rate (expressed in percentage).
The Reversion Cap Rate Metric: Why Is It Important?
On the surface, it would appear that the cap rate was the primary statistic to pay attention to; after all, isn’t what you’ll make throughout the project more important than what the “ultimate” rate will be?
The investment opportunity’s level of planning can be inferred from the reversion cap rate. In particular, you should search for reversion cap rates at least 0.5 percentage points greater than the project’s entrance cap rates. The fact that the contract is better overall may initially seem surprising because a higher cap rate is frequently desired.
The explanation is straightforward: a higher cap rate after the investment signifies that the partners on the deal are forecasting a cautious sale price on the project in case the market declines after the investment hold term. Additionally, it indicates that the market may decline if taken into account in all underwriting, financing, and deadlines.
In conclusion, investors should search for a reversion cap rate more significant than the going-in rate since it indicates that all predictions and underwriting account for the risk of a softening market.
You may determine the anticipated selling price by dividing the final year’s net operating income by the reversion cap rate. You will then know the property’s estimated absolute worth.
This indicator, in addition to numerous others, aids potential investors in deciding whether real estate ventures are worth their time and effort. Remember, however, that all investments risk loss before making any financial commitments.