Justifying reversionary cap rates

Justifying reversionary cap rates

It’s safe to say cap rates have been thrown out the window over the past few years. Admit it: We all gathered at conferences and chuckled about ridiculously low cap rates paid in gateway markets.  

When there is a steady stream of deal flow to a wider investment community, we will again have a good baseline for present day cap rates. But what about one of the most key factors in determining ROI: the reversionary cap rate?

Reversionary cap rates remain less science than sentiment, whereas we find ourselves looking at what we did in the past rather than examining where a market will be in the future. There is no formula or universally agreed upon source for determining a reversionary cap rate. Rather, it can be haphazardly penciled in to a large extent.

So, how can this be changed?

What if I told you that through second quarter 2011, Seattle and Chicago had nearly an identical ADR for the downtown upper-upscale tracts? Would this make you rethink a reversionary 6.5% cap in Chicago? Or an 8% cap in Seattle?

I found that in comparing current demand with future supply in a market helps predict where market performance will be moving forward. A simple formula for this (“absorption”) is taking the inverse of the percent change in future supply less the change in occupancy. When I first put this to the test three years ago, San Francisco ranked first in absorption of the STR top 25 hotel markets. This year, San Francisco ranks first in RevPAR growth.

Using the same absorption formula today, markets such as Denver, Detroit and New Orleans rank atop the 25 markets; New York (with one of it’s largest development pipelines in history) and D.C. are at the bottom. Does this say we should underwrite New York and Detroit to the same reversionary cap rate? Not a chance.

The point is, simple comparisons can help us determine whether to shift a present day cap rate up or down to effectively justify our reversionary rate. I would have no issue underwriting a Denver hotel to a full percentage less capitalization rate on reversion from where it is today based on the positive direction in which the market is headed.

Given that we are essentially starting from scratch in cap rate logic, it may be time to better hone in on this underwriting element that can make or break a deal.