Reversion cap rate is an important metric in multifamily. It is the cap rate you use when exiting the deal.
When it comes to cap rates you want to buy high and sell low.
Reversion Cap Rate Explained
The reversion cap rate you use can significantly impact the return on investment. If you buy a deal at a 7% cap rate and sell at a 4% cap rate you will make a great return.
Conversely, if you buy at a 4% cap rate and sell at a 7% cap rate you could lose money.
A good visual will help explain this using $1,000,000 in NOI and what an asset is worth at different cap rates:
Of course NOI will go up as you improve the property. However, it depends on the length of time the asset is held. A shorter hold will likely not overcome a reversion cap rate going higher.
As an example let’s say we bought a deal at a 4% cap with $1,000,000 NOI at the beginning of the year. NOI has gone up 20% to $1,200,000 but cap rate has gone up to 5%.
| NOI | Cap Rate | Asset Price |
| $1,000,000 | 4% | $25,000,000 |
| $1,200,000 | 5% | $24,000,000 |
Even though we did really well year one, we lost $1,000,000 due to the market. This is why reversion cap rate is really important.
Read More: Looming Multifamily Maturities in 2023
Speed of Rate Hikes
The rise in interest rates is the fastest in recent history. Last year majority of the financial media sentiment was the Fed will do a few hikes at a smaller amount.
This image from Visual Capitalist shows the comparison of rate hikes over the past 35 years.
This is what catches investors off guard. Having a higher reversion cap rate than what you purchase at can protect you from this downside on your pro forma.
However, as competition for multifamily heats up, reversion cap rates get squeezed. In order to make returns look more attractive the reversion cap rate is lowered.
Determining Reversion Cap Rate
A standard rule of thumb to determine reversion cap rate is to use 10 basis points per year the asset is held. A typical 5-year hold would mean you should use 50 basis points.
If you buy at a 5% cap rate and hold for 5 years it is safe to assume 5.5% for the exit. The biggest downside risk is being caught in a year like this if you are forced to sell.
Owners with long-term financing can usually afford to ride out a cycle. Someone that bought at a 4% cap rate on a 2-year note will likely lose money if forced to sell early at a 5% cap rate.
Conclusion
When making an investment decision on a multifamily property it is critical to look at the assumptions. Look at the pro forma and see where rents and NOI is projected to go but also look at reversion cap rate.
If the property is being purchased at a low cap rate and the assumption is that the cap rate will be the same or lower at sale you should question it.
