- What is Exit Cap Rate?
- How to Calculate Exit Cap Rate
- Exit Cap Rate Formula
- Exit Cap Rate Calculator
- 1. Commercial Real Estate (CRE) Building Assumptions
- 2. Terminal Value Calculation Example (Sale Price)
- 3. Exit Cap Rate Calculation Example
- Exit Cap Rate vs. Entry Cap Rate: What is the Difference?
- How to Project Cap Rates
What is Exit Cap Rate?
The Exit Cap Rate is the anticipated rate of return on an investment property at the end of the hold period, which is used to forecast the implied terminal value of the property on the date of sale.
How to Calculate Exit Cap Rate
The exit cap rate is the expected yield on a property investment on the date of asset sale.
The exit cap rate is a pro forma return metric used in the commercial real estate (CRE) market to estimate the terminal value of an investment property.
The terminal value refers to the future market value of a property on the date of exit (i.e. the anticipated sale price), and represents one of the core drivers of returns from the perspective of a real estate investor.
The exit cap rate – otherwise referred to as the “terminal cap rate” or “reversion cap rate” – is a critical component of conducting property investment analysis in the due diligence phase.
The exit cap rate is a variation of the capitalization rate on a more forward-looking basis, where the assumptions are based on the future date of sale.
The assumptions that underpin the exit cap rate include estimates around the future conditions of the real estate market (and economy) on the date of sale, the state of the market demand in a specific location, and the operating performance of the property.
Therefore, it is imperative to understand that the exit cap rate is a mere estimate of an investment property’s potential yield.
With that said, the variance between the reversion cap rate and the actual cap rate can be significant given the external variables that can influence the market cap rate, especially given its far reaching assumptions.
The calculation of the exit cap rate consists of the following steps:
- Perform Market Analysis → Collect market data relevant to the factors that can influence the property’s market value at exit, including developing trends near the property location and potential risks.
- Project Net Operating Income (NOI) → Forecast the net operating income (NOI) of the property based on the data collected on comparable properties and analysis on market demand.
- Determine the Exit Cap Rate → Insert exit cap rate assumptions derived from the market cap rate and other external factors. However, the exit cap rate can be manually back-solved by dividing the projected NOI by the terminal value of the property.
- Convert into Percentage → Express the exit cap rate as a percentage by multiplying the output by 100 to convert from decimal notation into percentage form.
Exit Cap Rate Formula
The formula to estimate the terminal value of the property on the date of exit requires the exit cap rate and the projected net operating income (NOI) at various potential sale dates.
The timing of the property sale is not known on the date of purchase, and is instead contingent on future market conditions, among various other factors.
In practice, real estate investors strategically “time” the exits of their investments to coincide with periods amid peak market valuations to derive the most profits post-sale, contributing to a higher return on investment (ROI).
The exit cap rate is estimated based on analyzing the market cap rate and property characteristics, among a plethora of other factors.
By rearranging the formula, we can calculate the implied exit cap rate, which can then be compared to the entry cap rate (“sanity check”).
Where:
- Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses
Net operating income (NOI) measures the operating profitability of a given property, with several commonalities to EBITDA.
Hence, NOI and EBITDA are standard measures of profitability used to perform comps analysis in their respective industries, as both metrics are capital structure independent, i.e. unaffected by financing decisions.
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We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Commercial Real Estate (CRE) Building Assumptions
Suppose a commercial real estate (CRE) investment firm is considering the acquisition of a commercial office building for $10 million near the end of 2023.
In the trailing twelve months (TTM), the office building generated $500k in net operating income (NOI).
- Net Operating Income (TTM) = $500k
- Expected Hold Period = 5 Years
The purchase price of the commercial building is $10 million, so after rearranging the purchase price formula, the implicit assumption for the entry cap rate is 5.0%.
- Purchase Price = $500k ÷ 5.0% = $10 million
- Entry Cap Rate = $500k ÷ $10 million = 5.0%
The NOI of the commercial building is expected to grow by $10k per year from the start of 2024 to the end of 2028 – the hold period of the property investment – causing the expected NOI to expand and reach $625k by the end of Year 5.
2. Terminal Value Calculation Example (Sale Price)
Based on the pro forma projections of the office building’s operating performance (and implied terminal value), the firm adjusts the exit cap rate according to the levers on hand for value creation and potential market risks.
Starting in 2024, the exit cap rate is assumed to increase by 10 basis points, or 0.1%.
Therefore, the exit cap rate reaches 5.5% by the end of 2028, which is 0.5% higher than the current market cap rate.
- Cap Rate Expansion (%) = 5.5% – 5.0% = 0.5%
Based on the insights derived from analyzing the commercial office building and the external factors at a macro level (i.e. prime rate, economic conditions) in addition to location-specific trends, the estimated exit cap rate is 5.5% on the date of sale.
- Exit Cap Rate (%) – Year 5 = 5.5%
The real estate firm can determine the terminal value of the property, or sale price, by dividing the office building’s net operating income (NOI) by the estimated terminal cap rate.
By the end of Year 5 – the anticipated time of exit – the implied terminal value of the property is $11.4 million, based on the projected 5.5% exit cap rate and $625k in net operating income (NOI).
- Expected Net Operating Income (NOI) – Year 5 = $625k
- Exit Cap Rate – Year 5 = 5.5%
- Terminal Value – Year 5 = $625k ÷ 5.5% = $11.4 million
Note: The terminal value is the estimated market value of the property from the perspective of the seller, not the actual sale price. For the implied return to be received, there must be buyers in the market willing to pay that price, i.e. the “spread” between the estimated market value and actual sale price deviates the further the exit date is from the purchase date.
3. Exit Cap Rate Calculation Example
In the final section of our exercise, we’ll solve for the implied exit cap rate manually, ignoring the fact that the figure was provided as an explicit assumption.
As mentioned earlier, the exit cap rate is calculated by dividing the expected net operating income (NOI) at exit by the terminal value.
The implied exit cap rate matches our original assumption of 5.5%, illustrating the relationship between the three variables (NOI vs. Cap Rate vs. Property Value).
In closing, the implied terminal value (or sale price) can be adjusted by the original purchase price to calculate the total exit proceeds. If the commercial building is sold in Year 5, the expected gross proceeds collected post-exit would be $1.4 million (or a 13.6% gain in property value).
- Exit Proceeds – Year 5 = $11.4 million – $10 million = $1.4 million (+13.6% Gain)
Exit Cap Rate vs. Entry Cap Rate: What is the Difference?
The exit cap rate and entry cap rate in real estate are distinct variations of the capitalization rate metric, where the differences between the two stem from the timing of the assumptions.
- Entry Cap Rate → The entry cap rate, or “going-in ” cap rate, is the estimated return as of the initial purchase date. The entry cap rate is determined by dividing the NOI of a property at stabilization by its current market value. Therefore, the entry cap rate is the expected yield on an investment property in the first year of operations.
- Exit Cap Rate → The exit cap rate, or “going-out” cap rate, estimates a property’s resale value at the end of the hold period, i.e. near the date of exit. The exit cap rate is estimated by dividing the projected net operating income (NOI) for the year of the anticipated property sale by the expected selling price at the date of sale.
The entry cap rate is also technically a pro forma measure of returns, since the net operating income (NOI) of the property is at stabilization.
However, the reversion cap rate is further reaching in terms of the time frame, since the implied return is set based on the exit date, or date on which the property sale occurs to realize a profit (or loss).
The exit cap rate is expressed as a percentage and serves as a benchmark for comparability between property investments in the market – i.e. real estate investors can compare the risk/return of comparable properties to determine the most attractive investments to allocate capital to.
How to Project Cap Rates
In the commercial real estate (CRE) market, it is standard practice for the exit cap rate to be set higher than the entry cap rate.
Why? By setting the exit cap rate marginally higher than the entry cap rate, the implied return becomes a more conservative measure of returns – akin to setting the exit multiple in an LBO model the same as (or below) the purchase multiple.
- Cap Rate Expansion → Lower Implied Property Value
- Cap Rate Compression → Higher Implied Property Value
Given the relationship between cap rate and property value, the odds of achieving a sufficient yield in excess of the minimum rate of return (“hurdle rate” ) are higher if risk-averse assumptions are used as part of the investment analysis.
The common rule of thumb among industry practitioners is to add 10 basis points (bps) for each year of the hold period.
However, the incremental uptick (or “step”) can be higher for higher-risk investments, where the estimated variance between the market cap rate at present and in the future is on the higher end due to uncertainty (i.e. the differential between the “Upside” case and “Downside” case is significant).
