When you build your financial model, you'll need to make some assumptions about what you're going to sell the property for to understand the long-term potential.
You want to avoid the speculation game and make some validated assumptions.
No one knows where the markets will be, so you want to airtight your framework, and properly estimating the selling price is key to making the right buys in the first place.
This is especially true when you are using external money - investors want to know their total exit return, and the core calculation is based on estimating what you think the property will sell for.
Overshoot, and you will piss a bunch of your investors and tarnish your rep.
For 1-4 units, the data is easily available on major platforms like Zillow and Realtor.
But >4 units are valued based on cap rates, which is a harder projection, so I wanted to share my solution.
It’s an output of me studying some of the bigger players with an extensive track record and how they project.
Let’s dive in.
First of all, what is the cap rate?
Cap Rate = Net Operating Income(NOI)/ Asset Price
or Exit asset price = NOI / Exit Cap rate.
So to estimate exit price, you will have to project an exit cap rate or, in other words, a cap rate that you think the next buyer will use to put an offer price.
The basic rule of thumb that many institutional and professional real estate investors use is what's called an annual cap rate expansion.
What that means is - in your analysis, you're going to assume some sort of cap rate increase every single year until you go sell the property.
This rule is about point 1% or 10 basis points per year.
So if you buy a property at a 5.0% cap rate in 2022, and then you go to sell that property at the end of 2027, you would assume a 5.5% exit cap rate.
For example, let’s say you just bought a property for $1 million, and your net operating income for that first year was $50,000.
Entry Cap Rate = $50,000/$1,000,000 = 5%
Let’s say in the next 5 years; the NOI goes to $70,000 with your rent projections.
And with our cap rate expansion formula of a .1% increase every year, the exit cap = 5.5 %
The total estimated exit price = $70,000/5.5% ~ $1.27M
Now, why would a cap rate increase, especially when you've added value to the property, which is a staple strategy for many?
Maybe you've done some rehab or leased up the property and added value to the deal, and usually, that means the cap rate should decrease when you sell.
That would be true, and I have seen some investors compress the cap rates, but I caution you there.
Cap rates generally track interest rates, which are rising atm, so there is no reason to compress the rates.
Even in low-interest periods like in the last couple of years, some investors do that because they can easily attract capital by showing a higher exit price.
I think that is an aggressive strategy.
I try to undershoot so I can overachieve for the investors, and I would always recommend some sort of cap rate expansion as you are analyzing your real estate deals.
Cap rate expansion is one way, but there is another data-driven way as well.↓
Suppose you are running a more extensive operation and have some capital to spare to get the best data out there; you can get historical cap rates for specific markets through Real capital analytics.
Real capital analytics allows you to see historical cap rates for a specific market over time.
So if you're looking at multifamily properties in Atlanta, and you want to put a little bit more data behind your exit cap rate assumption and see what the trend has been for cap rates for multifamily properties in Atlanta over time and make some validated assumptions, that is a more factual way.
It’s an enterprise solution, which could be a great route if you're a professional investor.
Otherwise, it might be cost-prohibitive for small-scale investors. So I'd recommend using the exit cap rate expansion approach, which is what I use :)
There you have it.
The right approach was a wild goose chase for me, so I hope this helps you save time and reduce risk.