Evaluating Cap Rates

[Nicholas Burch]

How do you estimate the ''exit cap rate'' on a commercial property? I understand that you can evaluate a sales price based on what the seller or broker presents as the cap rate and NOI, but how do investors determine their exit cap rate? Is this done with an appraisal or CMA to get market value and then apply your final holding year NOI? I provided a visual below.

[Immanuel Sibero]

It shouldn't be this complicated.

- I would not use seller or broker stated cap rates ever.

- It's certainly not done with an appraisal or CMA of a future value, it's hard enough to do an appraisal or CMA of a current value.

- I see that you already determined an entry cap rate (going-in cap rate). There is good argument to say that exit cap rate is a function of entry cap rate.

- Cap rate is more of a measure of market sentiment (bullish or bearish) in a particular geographical location. If the market (buyers and sellers) is bullish then cap rate will trend down in that area and vice versa. So if, for example, you purchase a property at 6% cap rate today then that's a good starting point. if you then plan to sell in 5 years and wonder what "exit cap rate" you should use, you should get a feel of what the market sentiment will be in 5 years. The area may be up and coming where market cap rate is projected to compress to 5%. You can then set your exit cap rate to 5%. But then again you may think that you should be conservative and set it back to 6%.

- Many syndicators choose to be conservative by estimating exit cap rate to be entry cap rate + some basis points. For example, if your entry cap rate is 6% you would estimate exit cap rate to be 6% + .5% (i.e. 50 basis points) which equals to 6.5%.

- Cap rate tends to track with interest rate and we all know what has been happening lately with interest rates. If there is ever a good time to set your exit cap rate higher than your entry cap rate it would be now.

Hope this helps.

Cheers... Immanuel