What is Exit Cap Rate?
The Exit Cap Rate is the anticipated rate of return on an investment property at the end of the hold period, which is used to forecast the implied terminal value of the property on the date of sale.
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How to Calculate Exit Cap Rate
The exit cap rate is a pro forma return metric used in the commercial real estate (CRE) market to estimate the terminal value of an investment property.
The terminal value refers to the future market value of a property on the date of exit (i.e. the anticipated sale price), and represents one of the core drivers of returns from the perspective of a real estate investor.
The exit cap rate – otherwise referred to as the “terminal cap rate” or “reversion cap rate” – is a critical component of conducting property investment analysis in the due diligence phase.
The exit cap rate is a variation of the capitalization rate on a more forward-looking basis, where the assumptions are based on the future date of sale.
The assumptions that underpin the exit cap rate include estimates around the future conditions of the real estate market (and economy) on the date of sale, the state of the market demand in a specific location, and the operating performance of the property.
Therefore, it is imperative to understand that the exit cap rate is a mere estimate of an investment property’s potential yield.
With that said, the variance between the reversion cap rate and the actual cap rate can be significant given the external variables that can influence the market cap rate, especially given its far reaching assumptions.
The calculation of the exit cap rate consists of the following steps:
- Perform Market Analysis → Collect market data relevant to the factors that can influence the property’s market value at exit, including developing trends near the property location and potential risks.
- Project Net Operating Income (NOI) → Forecast the net operating income (NOI) of the property based on the data collected on comparable properties and analysis on market demand.
- Determine the Exit Cap Rate → Insert exit cap rate assumptions derived from the market cap rate and other external factors. However, the exit cap rate can be manually back-solved by dividing the projected NOI by the terminal value of the property.
- Convert into Percentage → Express the exit cap rate as a percentage by multiplying the output by 100 to convert from decimal notation into percentage form.
Exit Cap Rate Formula
The formula to estimate the terminal value of the property on the date of exit requires the exit cap rate and the projected net operating income (NOI) at various potential sale dates.
The timing of the property sale is not known on the date of purchase, and is instead contingent on future market conditions, among various other factors.
In practice, real estate investors strategically “time” the exits of their investments to coincide with periods amid peak market valuations to derive the most profits post-sale, contributing to a higher return on investment (ROI).
The exit cap rate is estimated based on analyzing the market cap rate and property characteristics, among a plethora of other factors.
By rearranging the formula, we can calculate the implied exit cap rate, which can then be compared to the entry cap rate (“sanity check”).
- Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses
Hence, NOI and EBITDA are standard measures of profitability used to perform comps analysis in their respective industries, as both metrics are capital structure independent, i.e. unaffected by financing decisions.