Reversion Cap Rate: A Tool For Underwriting Exit Sales Value

Before we can understand precisely what the reversion cap rate is, it’s essential to understand the going-in market cap rate. The going-in market cap rate is the cap rate that similar commercial properties sell for in the same market. Once we have this number, we can begin effectively building out our proforma projections for where we believe we could take the terminal value of the property if we were to add some sort of value to it.

The reversion cap rate comes into play when we’re underwriting the deal’s exit value. The reversionary cap rate is a conservative way to stress test the exit value, which is performed by increasing the cap rate by a certain percentage. Generally, at Willowdale Equity, we’ll expand our reversion cap at least 0.5% (or 50 basis points) higher than the going-in market cap rate. So, for example, if the going-in market cap rate is 6%, we would use a reversion cap rate of 6.5% to underwrite the deal’s exit sales value.

The reversion cap rate is super crucial to underwriting the exit sales value. Although we are fundamental investors, we get paid for our ability to run complex underwriting modeling to predict future value; the honest answer is that interest rates are constantly changing, and markets are cyclical. 

With that being said, it’s essential to use this reversion cap rate that lowers the projected exit value, which in return gives us a better indication of whether the projected return hurdles can ideally be met throughout the hold of the project.

You see, most of the deal’s returns are based on the exit sales value, not the cash flow generated annually. Therefore it’s essential to get that exit value as close to accurate as possible to increase the accuracy of the return projections of the project.