Entry Cap Rate and Exit Cap Rate
An exit cap rate is the capitalization rate expected to apply when a property is sold. Dividing the NOI used in the sale valuation by that rate gives the sale price. The entry cap rate is the projected first-year NOI divided by the acquisition price. Each is a one-year NOI-to-price ratio taken at a different moment, and neither measures return over the hold.
Two one-year ratios taken at two different moments
The entry cap rate sits at acquisition. It divides projected first-year net operating income by the price paid. The exit cap rate, also called the terminal or reversion cap rate, sits at disposition. It is the capitalization rate expected at sale, and the arithmetic runs backward from the entry calculation: the underwriter picks the rate and divides the sale NOI by it to get a price.
That arithmetic fixes the direction of every sensitivity. For a given NOI, a higher exit rate gives a lower price and a lower exit rate gives a higher price.
A cap rate is one year of income over price. It does not measure IRR, yield over the hold or an equity multiple, because it leaves out debt payoff, fees, the cash flow collected during the hold and the timing of each.
“It is typically the projected first year’s net operating income divided by the acquisition price. Exit Cap Rate The exit cap rate, sometimes called terminal or reversion cap rate, is the expected capitalization rate at sale.”
Which NOI sits under the entry rate
The same purchase price can produce two different entry cap rates, depending on whether the numerator is trailing or projected NOI. In hotel segments, going-in cap rates built on projected first-year NOI ran 20 to 90 basis points above cap rates built on historical NOI. The gap reflects expected NOI growth: a larger numerator over the same price gives a higher rate.
That matters when an entry rate is set beside an exit rate. An entry rate on projected NOI already contains a growth assumption, and an exit rate applied to a sale-year NOI contains another. A spread between the two that mixes NOI bases measures the accounting choice as much as the market view.
The definitional anchor is that the entry rate uses projected first-year NOI. A quoted rate that does not say which NOI it uses cannot be compared with another quoted rate.
The exit rate is set by the market, so underwriting builds in a cushion
An owner can work on NOI through leasing and expense control. The exit cap rate is a market-driven rate at the time of sale, and the owner has no control over it. Underwriting therefore treats it as an assumption with a range.
Published cushions vary. One base case carries a 5.75 percent exit rate that already includes a 10 percent increase, applied on a straight-line basis at 2 percent per year. Other sponsor models have used 100 basis points of expansion over a 10-year hold and 50 basis points over a five-year deal. A private real estate manager underwrote 100 to 150 basis points of expansion between purchase and sale, and market cap rates then tightened during ownership.
That outcome shows a cushion is an assumption that may or may not play out. Rates can move either way, and an underwritten expansion that never arrives leaves a sale price below what the market paid.
Moves can also be sizable over short windows. In one quarter, multifamily cap rates rose 22 basis points to 5.8 percent, while apartment prices fell 1.2 percent for the quarter and 1.7 percent over the year. That is one asset class over one window, and it shows how a rising rate appears in price.
How credit analysis builds a gap between actual and stressed cap rates
Rating criteria for commercial mortgage securitizations apply a loan-specific cap rate that is typically more than 200 basis points above the loan’s actual cap rate. Where the gap is smaller, the criteria may adjust the rate to keep a cushion of up to 200 basis points above the actual rate.
The standard rates behind this are based on historical long-term averages. The effect is a loan value below what the actual cap rate would give, so a lender’s valuation and an exit assumption in an offering model can be built from different rates.
Worked example: a hypothetical $10 million acquisition sold at a 6 percent and a 7 percent exit rate
Hypothetical inputs: a property bought for $10,000,000 with projected first-year NOI of $600,000. The entry cap rate is $600,000 divided by $10,000,000, which is 6 percent. Debt is 60 percent of price, so the loan is $10,000,000 multiplied by 0.6, or $6,000,000, and equity is $10,000,000 minus $6,000,000, or $4,000,000.
Simplifying assumptions: acquisition costs are ignored. The loan is interest only and is repaid at sale. Sale costs are 2 percent of price. Sale-year NOI is $720,000, which is 20 percent above entry NOI ($720,000 divided by $600,000, minus 1). Both cases use the same equity and the same hold period.
Base case, exit rate equal to entry at 6 percent: $720,000 divided by 0.06 gives a sale price of $12,000,000. Sale costs are $12,000,000 multiplied by 0.02, or $240,000. After costs and the $6,000,000 loan payoff, equity receives $12,000,000 minus $240,000 minus $6,000,000, or $5,760,000. That is $5,760,000 divided by $4,000,000, or 1.44x, from sale proceeds alone and before any cash flow collected during the hold.
Stressed case, exit rate one percentage point wider at 7 percent (0.07 minus 0.06, or 0.01): $720,000 divided by 0.07 gives a price of about $10,285,714. Sale costs are about $205,714. Equity receives about $10,285,714 minus $205,714 minus $6,000,000, which is $4,080,000, or 1.02x on the $4,000,000.
The price falls by $12,000,000 minus $10,285,714, or about $1,714,286, which is 14.29 percent of the base price. Because the loan stays at $6,000,000, equity proceeds fall by $5,760,000 minus $4,080,000, or $1,680,000, which is 29.17 percent. A price decline of 14.29 percent removes about twice that share of the equity proceeds, because the debt balance does not move.
Mistakes that distort an entry versus exit comparison
Dividing entry-year NOI by an expected sale price does not produce an exit cap rate. The exit rate uses the NOI selected for the sale valuation over the sale price, and swapping the numerator changes what the ratio says. In the example, entry NOI of $600,000 over a $12,000,000 sale price gives 5 percent, while the sale-NOI ratio is 6 percent.
Comparing an entry rate on projected NOI with an exit rate on a different NOI basis, without naming the difference, mixes an operating assumption with a pricing assumption. Each ratio computes correctly, yet the apparent spread misleads.
Quoting a cap rate increase without a sale NOI leaves the value effect undefined. A one point move in the rate is worth a different dollar amount at $720,000 of NOI than at $600,000, so each case needs its own price calculation.
A cap rate is one year of NOI over price, so it does not measure IRR, yield or an equity multiple over the hold. In the example, the 1.44x and 1.02x outcomes depend on debt payoff, sale costs and any cash collected along the way, and the cap rate contains none of those.
Reading the percentage fall in price as the percentage fall in equity understates the damage when there is debt. Price fell 14.29 percent in the example and equity proceeds fell 29.17 percent, because the loan balance did not move.
Questions that make an exit cap rate assumption readable
Which NOI is capitalized at sale? The price follows directly from that numerator, so the basis has to be stated.
Does the entry rate use projected first-year NOI? The entry definition ties it to that figure and to the acquisition price.
What exit rate sits in the base case, and how far is it from the entry rate? A stated rate and a stated gap make the NOI-to-value calculation reproducible.
How does the price move when the exit rate widens and NOI is held constant? That isolates the rate effect from operating performance.
Is the rate change spread over the hold or applied at once? A straight-line increase and a single step at sale can reach the same endpoint.
Are net sale proceeds compared with the acquisition price or with invested equity? Those amounts sit at different stages and use different bases.
Do the stated proceeds include loan payoff and sale costs? Their inclusion changes cash to equity without changing the exit cap rate itself.
Which rate would a lender or rating criterion apply to the same asset? A cushion of up to 200 basis points above the actual rate is one published convention for stressed value.