What is Terminal Cap Rate?
The Terminal Cap Rate is a real estate yield metric relied upon to estimate the anticipated sale price of a given property. Conceptually, the terminal cap reflects the rate of return that a real estate investor expects to earn on a property on the date of sale, i.e. the exit date.
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How to Calculate Terminal Cap Rate
The terminal cap rate is determined by the prevailing market conditions in the real estate (and credit) markets on the date the seller anticipates exiting the property investment.
The real estate investor can set their own sale price, but the state of the real estate market ultimately decides the exit valuation of the property, i.e. the supply and demand dynamics in the market.
Therefore, a real estate investor must understand the terminal cap rate is merely an estimate, rather than the actual return realized on the date of exit.
The actual cap rate on the date of the official sale – in which ownership of the property changes hands – can deviate substantially from the terminal cap rate computed by the property owner.
The property owner’s bias often inflates the property value, yet the actual determinant of the sale value is due to the market conditions – hence, the importance of timing the exit right.
- Project Net Operating Income (NOI) → To calculate the terminal cap rate, the first step is to project the property investment’s future net operating income (NOI) on the date of the sale.
- Calculate Anticipated Sale Price → Using the property’s expected net operating income (NOI), the anticipated sale price can be calculated by multiplying the terminal cap rate by the expected NOI.
One common misconception is that the terminal cap rate is a subjective measure set by the seller, i.e. at random. In fact, the actual sale price is influenced by factors such as current market conditions, trends in the economy (and location), and the outlook on the market by investors on the date of sale.
Terminal Cap Rate Formula
In the formula to calculate the anticipated sale price at exit, the expected net operating income (NOI) of the property on the date of sale is divided by the terminal cap rate.
The net operating income (NOI) measures the profitability of a property, net of any direct operating expenses incurred.
The effective gross income (EGI) is equal to the sum of a property’s rental income and ancillary income, net of vacancy and credit losses.
By rearranging the formula, we can solve for the terminal cap rate.
Therefore, the net operating income (NOI) shares numerous commonalities with EBITDA, and practitioners widely used the two metrics, namely because of their comparability.
Why? Both NOI and EBITDA are capital structure independent metrics, so unaffected by discretionary financing decisions, jurisdiction-dependent income taxes, and accounting methods.
The net operating income (NOI) is computed prior to any debt costs (e.g. principal, interest payments), capital expenditures (Capex), and non-cash add-backs such as depreciation.
