All Forum Posts by: Nicholas Burch

There is no exact mathematical formula for this..unfortunately.  And the exit cap rate is the single most important cell in your underwriting model.  Lots of people pencil whip that number to get a deal work because a lower cap rate moves the needle a ton on overall return figures. My rule of thumb is to use a minimum of 50 bps higher on the exit cap vs going in cap.  If my going in cap is super low (due to value add) then I'll go even higher than that. Use your best judgment, but make sure to remain conservative here. 

@Nicholas Burch

The going-in cap rate is the projected first-year NOI divided by the initial investment or purchase price. In contrast, the terminal capitalization rate is the projected NOI of the last year (exit year) divided by the sale price. If this rate is lower than the going-in cap rate, it usually means that the property investment was profitable.

Most real estate investing professionals agree that it's important to match the terminal capitalization rate to the current rate of the market, keeping in mind that it may be a safer test for the development to nudge the terminal cap rate up a bit. A dynamic spreadsheet can be useful to stress test the development project to establish the highest terminal capitalization rate that would still provide a sufficient upside to investors.

Savvy real estate investors look for markets and property types for which market capitalization rates are expected to fall since a lower terminal capitalization rate, compared to the going-in cap rate, will result in capital gains, assuming that the NOI will not decrease over the holding period. Some of the data that must be considered includes supply-and-demand metrics for each category of space, as well as for the services and expenses assumed to be related to each area of operation.

While the future is always uncertain, two things are certain about the end of any holding period: the buildings will age and the markets will change. It's thus critical that all real estate investors compile and analyze as much data as possible to accurately pinpoint a terminal capitalization rate for a project.

All the best!

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

Good question and some will disagree here, some backstory on capitalization rate and IRR, they're ever changing. A cap rate is a one time snap shot that will change, sometime immediately after the sale like property taxes increase will cut into NOI and it depends on mgmt, inflation, expenses, lease type (ie gross, nnn, etc ). IRR is a projection metric and can fail to consider some assumptions like capital expenditures, repairs not lease covered. IRR can only accurately calculated after the sale. But I know that not what you're asking here, the short answer is dividing the NOI by your anticipated sales price , but how do you arrive on the sales price? Factor in a prevailing cap rate might be different in 5,10 years than today.