Your Exit Cap Rate Is Doing More Work Than Your Business Plan
The exit cap rate applies to the largest cash flow in a real estate model and is a pure assumption about a future market. Here is how much it moves returns, and how to underwrite it honestly.
On a typical five year multifamily hold, 60% to 80% of everything an investor receives arrives in a single lump at the end. That lump is reversion value, and it is produced by dividing final year NOI by an assumed exit cap rate.
Which means one assumption, about a market five years out, determines most of the return. It is worth being deliberate about it.
How much it actually moves
Take a $6,000,000 acquisition at a 6.5% going-in cap rate, five year hold, with a business plan that grows NOI to $505,000 by year five.
| Exit cap rate | Reversion value | Levered IRR |
|---|---|---|
| 5.75% | $8,783,000 | 21.4% |
| 6.25% | $8,080,000 | 18.2% |
| 6.75% | $7,481,000 | 15.2% |
| 7.25% | $6,966,000 | 12.4% |
A 150 basis point range in the exit assumption swings IRR by roughly nine points. No operational decision available to you during the hold has that kind of leverage. You could execute the renovation program flawlessly, beat your rent targets, and still land at the bottom of that table because the market repriced.
Why compression is not a plan
The temptation is to underwrite the exit at or below the going-in rate. The reasoning usually offered is that the asset will be better after the business plan, or that rates will have fallen by then.
The first argument confuses the asset with the market. Cap rates price risk and growth expectations for a market and a property class, not the quality of your renovation. A better-operated asset earns a higher NOI, which the model already captures. Crediting it twice, once in income and again in the cap rate, is double counting.
The second argument is a rate forecast, and rate forecasts embedded in a real estate model are usually invisible to the people approving it. If the deal requires rates to fall, that should be stated plainly as the thesis rather than buried in an input cell.
The asset is also five years older at sale, which under any consistent view of cap rates argues for mild expansion rather than compression.
The convention that keeps you honest
Expand the exit cap rate 25 to 50 basis points over the going-in rate for a five year hold. Longer holds, older assets, and tertiary markets argue for more.
This is not a prediction. It is a discipline. Its purpose is to prevent the model from generating returns out of an assumption nobody defended, and it costs you nothing when the market cooperates.
If the deal clears its hurdle with an expanded exit, you have a deal that works on the plan. If it only clears at a compressed exit, you have a bet on the market. Both can be worth making. Only one of them should be made accidentally.
What to actually show the committee
A point estimate of IRR is close to meaningless without the grid behind it. The two variables worth putting on the axes are exit cap rate and rent growth, because they are the two that dominate and the two that are least under your control.
Three things that grid should tell you:
- Where the deal breaks. The exit cap rate at which returns fall below your hurdle. If that is only 25 basis points away from your base case, the deal has no margin for error.
- How much of the profit is reversion. Above 80% and the deal is an exit-pricing bet regardless of how the business plan is described.
- Whether the base case sits in the middle. If the base case is at the optimistic edge of the plausible range, it is not a base case.
Any investment committee will ask for this. Building it before they ask is the difference between defending a number and discovering it.
MultiScreen generates the exit cap and rent growth sensitivity grids automatically on every deal, along with the reversion share of total profit.
Terms in this post
- Exit Cap Rate
The exit cap rate is the capitalization rate assumed to apply when a property is sold at the end of the hold period, and it converts projected final-year net operating income into an assumed sale price.
- Reversion Value
Reversion value is the projected gross sale price of a property at the end of the hold period, calculated by dividing the final year's net operating income by the assumed exit cap rate.
- Internal Rate of Return (IRR)
The internal rate of return is the annualized discount rate at which the present value of a deal's cash flows equals zero, making it the time-weighted compound annual return on invested equity.
- Capitalization Rate (Cap Rate)
A capitalization rate is a property's net operating income divided by its purchase price, expressed as a percentage, and it represents the unlevered annual yield the property produces at that price.
More reading
- How to Underwrite a Multifamily Deal: A 7-Step Framework
A practical, repeatable framework for underwriting a multifamily acquisition, from rebuilding NOI off the T12 through sizing debt, modeling the business plan, and pressure-testing the exit.
- Cap Rate vs. Cash-on-Cash vs. IRR: Which Metric Actually Matters
Four return metrics answer four different questions, and using the wrong one is how deals get mispriced. A practical guide to when cap rate, cash-on-cash, IRR, and equity multiple each apply.
- How to Read a T12: 9 Red Flags in Multifamily Financials
The trailing twelve is the primary evidence base for underwriting a multifamily acquisition. Here are the nine things experienced buyers look for, and what each one usually means.