How to set the exit cap rate in a real estate model
One assumption is doing 60 percent of the work in your model, and most people set it by feel.
By the CRE Modelling team
It is the exit cap rate. Here is why it matters more than anything else you will spend three days building.
Where the value sits
On a ten year hold, the terminal value is typically somewhere between half and two thirds of the total value in the deal. That value is your final year NOI divided by your exit cap.
Move the exit cap 50 basis points and you can move the IRR by 150 to 250 basis points on a leveraged deal. That is the difference between a deal that clears the hurdle and one that does not. Your rental growth assumption, which you agonised over, moves it far less.
What 50 basis points does
Take a building bought for £20.0m at a 5.0% yield with a flat £1.0m NOI, held for ten years with no debt. Only the exit cap changes:
| Exit cap | 4.5% | 5.0% | 5.5% | |
|---|---|---|---|---|
| 1 | Final year NOI | £1.00m | £1.00m | £1.00m |
| 2 | Terminal value (NOI ÷ exit cap) | £22.2m | £20.0m | £18.2m |
| 3 | Change against the base case | +£2.2m | – | –£1.8m |
| 4 | Unlevered IRR, ten-year hold | 5.9% | 5.0% | 4.3% |
Unlevered, with no growth, 50 basis points is already 70 to 90 basis points of IRR. Put debt in the structure and the swing is larger: that is where the 150 to 250 comes from.
How to set it
- Start at entry cap, not at a market average.
- Add 25 to 50 bps for the ten years of age the building will have gained.
- Add more if the lease structure shortens or the sector is structurally out of favour.
- Only compress it if you can name the specific reason (a repositioning, a lease regear, a sector rerating) and you are willing to defend it.
Exit cap equals entry cap is not conservative. It is an assumption that the world stands still for a decade.
Say why, or do not move it.