Going-in versus exit cap rate
Also called Terminal cap rate, Exit cap, Reversion cap rate.
The going-in cap rate is year-one NOI divided by the purchase price. The exit or terminal cap rate is the rate applied to the forward NOI at the end of the hold to estimate the sale price. The spread between them is one of the largest and least evidenced assumptions in any underwriting.
How it works
The convention in institutional underwriting is to exit at a cap rate 25 to 50 basis points above the going-in rate. The reasoning is straightforward: the building will be five or ten years older at sale, its remaining economic life is shorter, and assuming otherwise means assuming a buyer will pay more for an older asset in an unknown capital market. Holding the exit cap equal to the going-in cap is a real assumption that should be stated out loud, and expanding it is the conservative choice.
The second convention that matters is which NOI gets capitalised. A buyer at the end of your hold is buying the income of the year that follows the sale, so the exit value should be built on FORWARD NOI, the year after the last year you own it. Capitalising the final year's trailing NOI understates the sale price by roughly one year of growth, which on a five-year hold is not a rounding difference.
Because the sale proceeds usually dominate a levered return, the exit cap does more work in an IRR than any other single input. It deserves a two-way sensitivity against exit timing or rent growth, not a single point estimate, and the downside case should assume expansion rather than compression.
Formula
Gross sale price = forward NOI / exit cap rate- Forward NOI is the year after the final year of the hold, not the final year itself
- Net proceeds subtract selling costs, typically 1 to 2 percent, and repay the outstanding loan balance
- Convention is exit cap = going-in cap + 25 to 50 basis points, and any tighter assumption should be justified
Worked example
Five-year hold. NOI grows to $3,497,787 in year five and $3,602,721 in year six. Going-in cap 5.40 percent.
| Exit at 5.40% (no expansion) | $66,717,056 |
|---|---|
| Exit at 5.75% (35 bp expansion) | $62,656,017 |
| Exit at 6.00% (60 bp expansion) | $60,045,350 |
| Capitalising year-five NOI at 5.75% instead of forwardunderstates by $1,824,939 | $60,831,078 |
| Value of 25 basis points at exit | about $2,610,000 |
Twenty-five basis points is roughly $2.6 million, which is about 13 percent of the equity in this deal. The single most consequential number in the model is the one with the least evidence behind it.
The common mistake
Exiting at the going-in cap because the deal needs it to work
When a return falls short, the exit cap is the easiest input to move and the hardest for anyone to challenge, because nobody can prove what caps will be in five years. That is exactly why it should be fixed by policy before the model is built rather than solved for afterwards. If a deal only clears its hurdle at a flat or compressing exit cap, the honest statement is that the deal requires cap rate stability, and that is a market call, not an underwriting result.
Related terms
- Cap rateA cap rate is a property's net operating income divided by its value or price, expressed as a percentage. It is the unlevered first-year yield on the purchase price and the standard shorthand for what a market is paying for a stream of property income.
- Internal rate of returnThe internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualised percentage.
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
- Yield on costYield on cost is stabilised net operating income divided by total project cost, including land, hard costs, soft costs, financing costs and carry. It is the development and value-add equivalent of a cap rate, and the spread between it and the market cap rate is where the profit comes from.
- Equity multipleThe equity multiple is total distributions divided by total equity contributed, expressed as a multiple. A 2.0x means an investor received two dollars back for every dollar put in, counting the original dollar.
- Percentage rentPercentage rent is additional rent a retail tenant pays based on sales above a threshold called the breakpoint. It gives the landlord participation in a tenant's success while keeping base rent at a level the tenant can carry in a weak year.
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.