Unpopular Opinion: Should You Always Raise The Exit Cap Rate When Underwriting

Unpopular opinion: No.

People who underwrite deals and rarely if ever buy deals say that you should always underwrite for an increase of usually at least a 10 basis point per year increase.

The problem with that is it only works when times are good. It assumes things can only get worse and never better. When prices have dropped significantly in a down cycle, a higher exit cap rate assumes another significant drop in pricing.

In the recession from interest rate hikes in 2022-2024, prices dropped around 20%. The only people transacting were underwriting for the same or sometimes even a lower exit cap rate than at acquisition. They were mitigating the risk through having significant reserves up front along with securing financing that protected the downside the best it could. In extreme examples like with Grant Cardone, he bought hundreds of millions worth of assets paying all cash through his equity raise.

To me, the people who purchased these deals are the true skilled investors. As we'll see, these are also the investors who actually get the best results. To me, the good investors are not the ones who play it so "conservatively" that they never transact in down markets.

So today what happened to the people who bought with the exit cap rate the same in their underwriting?

In September 2024, the Fed reduced the interest rates by 50 basis points in one meeting. Overnight, transaction volume skyrocketed and capital flowed into the industry. People could make the deals pencil out with the lower interest rates and asset prices rose around 10% immediately.

The people who had the temperament to buy at the right time now likely have around a 30%-40% return stored in the equity of the deal in a short amount of time.