Exit cap rate

An exit cap rate, also called a terminal or reversion cap rate, is the cap rate a developer or investor assumes buyers will accept when the building is sold at the end of the planned holding period. Divide the projected net operating income in the year of sale by the exit cap rate and you have the assumed sale price, which is often the largest single cash flow in the whole investment.

Because no one knows what cap rates will be in five or ten years, the exit cap rate is a judgment. A common practice is to assume it will be somewhat higher than today's, to reflect the building's age at sale and the risk that market conditions worsen. A lower assumed exit cap rate flatters a projection; a higher one is conservative.

Assume the building's NOI at sale is $1,500,000. At a 5.5% exit cap rate the sale price is $27.3 million; at 6.5% it is $23.1 million. A one percentage point difference in one assumption changes the projected sale by more than $4 million, which is why lenders and investors test this number carefully in underwriting.

The exit cap rate matters for housing costs because it shapes the internal rate of return a project shows, and therefore whether investors fund it. When interest rates rise and buyers expect higher cap rates in the future, projected sale prices fall, projected returns fall, and projects that were feasible at yesterday's exit assumption are not feasible today, regardless of construction cost.