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.
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.
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
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!
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.
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.
To make sure I understand your answer, a CMA is used to calculate the prevailing cape rate? Or do owners like to price their property based on another metric?
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
Thank you for that detailed response Immanuel. I see that I have quite a bit of learning to do. I need to learn how markets compress or expand cap rates and how interest rates affect cap rates. Also, I need to understand how basis points are derived.
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!
Thank you for that detailed answer. I am curious, what economic metrics do you use to evaluate terminal CAP?
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.
Thanks Brock,
I look forward to working with you in the future. Do you agree that the exit CAP rate should be lower than the entry CAP rate to reflect profitability?
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.
Thanks Brock,
I look forward to working with you in the future. Do you agree that the exit CAP rate should be lower than the entry CAP rate to reflect profitability?
Not necessarily. general aging of the property would indicate cap rate increases, but if youre adding value with stronger capex or better tenants/leases, then the cap rate can go down. of course, it all assumes interest rates are identical to lending at entry.
Like many things in real estate investing, the definition of a “good” cap rate is relative. Unfortunately, there is no number that an investor could point to and say “this is a good terminal cap rate.” Instead, the assessment of whether a terminal cap rate is good is highly dependent upon a variety of factors including:
growth rate of future cash flows,
anticipated market rents at the time of sale,
vacancy rates,
property type, and
market conditions.
As such, the closest a real estate investor can get to a “good” terminal cap rate is one that is close to those obtained in historical sales of comparative properties, adjusted for expected market conditions at the time of sale.
For example, if the cap rates for historical commercial property sales are 6.5%, but the estimated terminal cap rate for a potential investment is 5%, this is a likely indication that the estimated sale price is too high. But, if the market average is 6.5% and the estimated terminal cap rate is 6.6%, the real estate investor has a stronger case that their terminal value is supported by the current and historical market.
All the best!
I heard a good rule of thumb that keeps your exit conservative.
Add five bps for each year you expect to hold the property.
Ex: Buy a 6.00% cap. Hold five years. Exit 6.25% cap.
Just a rule of thumb. There are many situations where this does not work or shouldn't be used.