What it means
A cap rate (capitalisation rate) is a property's annual net operating income divided by its price, and it expresses the yield a buyer is willing to accept. Investors forecasting a sale several years ahead must guess what rate the next buyer will demand.
That guess is the exit cap rate. The sale price is estimated by dividing the net operating income expected in the year after the sale by the exit cap rate.
Lower rates mean higher values, and higher rates mean lower values, so the choice has a large effect on the projected return. Because the sale usually accounts for a big share of total profit, the assumption deserves careful thought.
Most analysts set the exit cap rate slightly higher than the rate at which they buy, often by 0.25% to 0.50%. This is conservative, since the building will be older, and future market conditions are unknown.
Assuming a lower exit rate than the entry rate suggests the investor expects the market to improve, which is optimistic and should be justified. The rate is shaped by interest rates, property type, location, tenant quality and lease length.
A building with long leases to strong tenants will command a lower rate than one with short leases and vacancies. Always run a sensitivity table that shows returns at several exit cap rates.
If an investment only works when the exit rate is lower than today's, the project is leaning on market luck rather than on its own performance. The exit cap rate also feeds the terminal value in a discounted cash flow model of a property.
The projected sale price is discounted back to today along with the yearly rental cash flows, so any change in the exit assumption flows straight into the internal rate of return. This is why lenders and investment committees often ask to see the exit rate before anything else.
In practice
Real-world examples
Example 1
A fund buys an apartment complex at a 5.5% cap rate and models its sale in seven years at 6.0%. The extra half point builds in a margin of safety for ageing. Lenders usually prefer to see a buffer between entry and exit assumptions.
Example 2
A developer's lender asks for returns at exit cap rates of 6%, 7% and 8%. The project still breaks even at 8%, which reassures the bank. This stress test shows how much room the project has before the investors lose money.
Example 3
An investor reviewing a broker's proposal notices that the sale assumes an exit cap rate lower than the purchase rate. She asks for the figures to be rerun with a more cautious assumption. The lower figure is not wrong in itself, but it needs a clear reason.
Think of it
Think of the exit cap rate like checking the resale value of a car before you buy it. You estimate how much milk the engine will still have in it and what buyers will pay for that mileage years from now.
Formula
Calculation
Projected sale price = Net operating income in year after sale / Exit cap rate
Net sale proceeds = Projected sale price - Selling costs
A fictional office block, Parkview Plaza, is expected to produce $600,000 of net operating income in the year after sale. At an exit cap rate of 6%, the price is $600,000 / 0.06 = $10,000,000. At 7.5%, it is $600,000 / 0.075 = $8,000,000, a $2,000,000 drop from a 1.5 percentage point change. With selling costs of 2%, the $8,000,000 sale nets $8,000,000 - ($8,000,000 x 0.02) = $8,000,000 - $160,000 = $7,840,000.Case study
Seen in the real world
Harbourlight Capital is an illustrative, fictional property investor evaluating a warehouse. Its first model used an exit cap rate of 5.0%, matching the purchase yield, and projected a 16% annual return.
An analyst questioned the assumption, pointing out that the warehouse would be ten years older at sale and that its main lease would be near expiry. Raising the exit cap rate to 6.0% reduced the projected sale price by about 17% and cut the return to 9%.
In the illustrative decision, the committee approved the deal only after the price was negotiated down and a lease extension was secured. The case shows how a seemingly small input can decide whether an investment is attractive. The committee now requires every proposal to show returns at three different exit cap rates.
Watch out
Common mistakes
- Setting the exit cap rate lower than the entry rate without evidence that the market will strengthen.
- Applying the rate to current income rather than the income expected in the year after sale.
- Forgetting selling costs, which reduce the cash the investor actually receives.
Questions
People also ask
What is an exit cap rate?
It is the capitalisation rate used to estimate a property's resale price at the end of the investment.
Should the exit cap rate be higher or lower than the entry rate?
It is usually set slightly higher to be conservative, because the property will be older and the future market is uncertain.
How does it differ from the going-in cap rate?
The going-in rate is based on the purchase price and current income, while the exit rate is a forecast of the rate at sale.