Interest rates will be rising in the next year or so and it is important to recall where they have been historically before the Fed started to manipulate the market. In the thirty years form 1977 to 2007 they averaged 7.597%. In the 21 years form 1987 to 2007 they averaged 6.19%. and since 1997 to 2007 it was 4.99%. It is important to note that the period form 2001 onward we one in which the Fed was pushing rates to artificially low levels and so there is a downward bias in the latter years. So if you look at 1987 to 2000 the average was 7.07%.

The point of all of this statistics is that when you think about exit values and cap rates five years, you need to understand that the ten year really can be at 6% or even higher, depending on your forecast for macro circumstances which could be in effect at that time. While none of us can predict what will be the situation in 2018, it is safe to say it will not be what it is today. There will be a new administration, the deficit may be far worse or maybe Washington actually did something about entitlement reform and deficit reduction. Maybe there was a war with Iran in 2013 and the Mideast exploded and oil is $200. Maybe a lot of things and black swans. We have no way to predict any of this with any reasonable degree of confidence.

It is probably safe to say if rates are still down near where they are today, then the economy is in really bad Japanese style deflation and we have much worse problems. Values would then be down far more from today's values. I doubt that will be the case and it far more likely that the economy will have revived, at least to some degree and rates on the ten year will have risen again. It may be that the dollar suffered excessively in the currency wars which currently are happening and the Fed has to raise rates to provide a floor for the dollar.

When you  underwrite your exit in 5 or more years you have to make some assumptions for underwriting purposes. Most likely you will run a couple of scenarios since the future is so impossible to predict these days. The key driver will be rates for the ten year since they impact net cash flow to the equity and debt service coverage for the buyer. Thereby we get to a reasonable leverage level to forecast and then to cash on cash returns to the buyer to see what is a reasonable level of future value that you can project.

It seems to me that to be safe and conservative, and one might add realistic, you need to run a scenario with the ten year at 6% and then stress it to 7% with a best case of 5%. Since 7.597% is the 30 year average then 7% is not unreasonable as a possible scenario. The best case was 4.99% from 1997 to 2007 so 5% is the reasonable best case.

One can argue that if rates are back at 7%, then the economy is probably doing well and rents will be moving higher faster. It is also possible that the debt markets will be more accommodating and leverage will be back at 75%. All of this is possible and unknown. Therefore you need to make a choice of metrics. In my view it is likely reasonable to use a 6% ten year with a spread not too far off today's spreads. At least that is a rational basis to proceed from. It is also not unreasonable to assume the economy is somewhat better and maybe GDP is growing at 3%. Cap rates then will be higher than today by maybe 1% or 3%. Depends on how you see the years after 2018, which is really impossible to see. You can be reasonably assured that with the ten year at 6%, cap rates will be a couple of percent higher.

Whatever you do is a gut call and it depends on how long you have been in the business. If you have been around for over 20 years you will usually be more realistic and conservative having been through as much as we have been since 1993.  If you were around in the eighties as I was, you will recall prime at over 20%, and inflation at 14%. You will also recall the S&L crisis, the Japanese rushing in to overpay, and then the downdrafts after each upturn. Those things teach one to be conservative and not to assume bright lights and happy days forever.

You have to make your own assumptions, but I merely remind you of the reality of index rates in more normal markets and to prepare well for them to be materially higher when you try to exit.