What it means
Property investors rarely hold a building forever, so a valuation needs a forecast of the sale price. The terminal capitalization rate, sometimes called the reversion or exit cap rate, is the tool used to turn the buyer's expected income into that price.
A capitalisation rate (cap rate) is net operating income divided by property value, which shows the yield a buyer gets. Turning this around, value equals net operating income divided by the cap rate.
Analysts usually set the terminal rate slightly higher than today's rate for similar properties. The reason is that the building will be older at sale, future rental growth is uncertain, and being cautious avoids relying on rising prices.
This one assumption has a very large effect on a discounted cash flow valuation, because the sale price often makes up most of the total value. A change of half a percentage point can shift the resale value by hundreds of thousands of dollars.
It is based on income in the year after the sale, because the buyer is purchasing the right to receive future income, not past income. The analyst therefore forecasts one extra year beyond the holding period.
Some analysts build the terminal rate from two parts: the current market rate and an adjustment for age and risk. Others compare it with the rate for the original purchase and ask whether the market would plausibly be more favourable ten years later.
Whichever method is used, the assumption should be written down and tested against other scenarios.
In practice
Real-world examples.
Example
A property fund is valuing an apartment block with a planned 7-year holding period. The analyst sets the terminal cap rate half a point above the current market rate. This gives a more cautious sale price for the investment committee. He shows how the value changes if the rate rises by half a point.
Example
A bank's valuer is checking a developer's forecast for a shopping centre. She notices the developer used a terminal cap rate lower than today's, which pushes up the exit value. She asks for a higher rate and a sensitivity table. The bank then bases its loan amount on the more cautious value.
Example
A family office compares two warehouses for purchase. The first has a short lease and the second a long lease with a strong tenant, so the analyst uses a higher terminal rate for the first. The difference reflects the risk of vacancy at sale. The analysis helps the family office decide how much to bid.
Formula
Calculation
Terminal value = net operating income in the year after sale / terminal cap rate
An investor plans to sell an office building at the end of year 5. The forecast net operating income for year 6 is $1,050,000, and the terminal cap rate is 7%.
Terminal value = 1,050,000 / 0.07 = $15,000,000
After selling costs of 2%, the net sale proceeds are 15,000,000 x 0.98 = $14,700,000.
If the rate were 8%, the value would be 1,050,000 / 0.08 = $13,125,000, which is $1,875,000 lower.Case study
Seen in the real world.
Greystone Property Partners is an illustrative, fictional investor weighing a purchase of an office tower. Its model forecast income of $2,000,000 in the year after a planned sale in year 8.
The base case used a terminal cap rate of 7.5%, giving a sale value of about $26,667,000. A junior analyst showed that at 8.5% the value would drop to about $23,529,000, a difference of more than $3,000,000.
The investment committee decided to use the higher rate for its offer and to ask the seller for a lower price. The illustrative lesson is that the terminal rate deserves as much scrutiny as the headline purchase price. Greystone's committee now insists that every property model includes a table showing sale values at three different terminal rates.
Watch out
Common mistakes.
- Using the same cap rate for the sale as for the purchase, without allowing for a more aged building. A buyer will be paying for an older building, so most analysts add a margin to the entry rate.
- Applying the rate to income in the final year of the holding period, rather than the year after the sale. The buyer receives the income after the purchase date, so that is the figure to capitalise.
- Ignoring selling costs when estimating the cash the investor actually receives. Agent fees and legal costs can reduce the proceeds by a few per cent of the price.
Questions
People also ask.
Why is the terminal rate usually higher than the entry rate?
A buyer in the future will be taking on an older asset and an uncertain market, so a cautious rate guards against over-optimism.
Where does the rate come from?
Analysts base it on recent sales of comparable properties, market surveys and professional judgment. Surveys of recent sales in the same city and property type give a useful starting point.
How sensitive is the value to the rate?
Very, because the sale value is net operating income divided by the rate, so a small change in the rate moves the result sharply. Analysts therefore show a range instead of a single figure, and because the rate is a forecast made years in advance, the aim is to be realistic rather than exact.
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