If you’re new to investing in real estate, there are probably many terms you don’t know. One term you may have heard is “reversion cap rate.” But what does this mean?
In order to understand this, you first need to understand the terminal cap rate. Once you know that, the concept of reversion cap rates will be much easier to grasp.
What is a Terminal Cap Rate?
A terminal cap rate is the expected rate of return on an investment property at the end of its holding period. It is also referred to as the “sell-off rate.” It is important to note that it differs from the current cap rate.
The current cap rate is the net operating income (NOI) ratio to the property’s current market value. Conversely, the terminal is the expected NOI at the end of the holding period divided by the estimated sale price.
In order to calculate it, you need to estimate the NOI at the end of the holding period and the sale price. This can be difficult if you don’t have a crystal ball!
What is a Reversion Cap Rate?
It is the expected cap rate at the end of the holding period, assuming that the market conditions revert to the original purchase conditions.
Ultimately, it is the projected return on investment if conditions in the market go back to where they were when you originally bought the property.
For example, if you purchase a property for $100,000 with a current cap rate of 12%. This means that the property is currently generating an NOI of $12,000.
For instance, the market conditions change over the next five years, and the property’s value increases to $200,000. The current cap rate would be lower since the NOI has stayed the same, but the property’s value has doubled.
Why is this important?
Because when you’re analyzing a potential investment property, you need to consider not only what the cap rate is today but also what it might be in the future. If you’re planning to hold the property for a long time, then the current cap rate is more critical than the reversion.
But if you’re planning to sell the property in a few years, then the reversion cap rate is more important than the current.
Remember that predicting future market conditions is difficult, so you shouldn’t put too much weight on the reversion rate.
Factors that Affect Reversion Cap Rates
The current economic conditions
If the economy is doing well, people are more likely to invest in real estate, which can drive up prices and lower cap rates. Conversely, people may be less likely to invest in real estate if the economy struggles, leading to lower costs and higher cap rates.
The property’s location
Properties in prime locations usually have lower cap rates than those in less desirable areas. This is because prime locations are more sought after and command higher prices.
The type of property
Different types of properties can have different reversion cap rates. For example, office buildings tend to have lower cap rates than retail properties. This is because office buildings are generally seen as a more stable investment and command higher prices.
The quality of the property
Like location, the quality of the property can also affect its reversion cap rate. Properties that are well-maintained and have high-quality finishes will usually have lower cap rates than those that need repair or have lower-quality finishes.
If you want to learn more about reversion cap rates or if you’re thinking about investing in real estate, many online resources can provide you with more information. You can also speak to a real estate professional to get their opinion on these rates and how they might affect your investment.