What belongs in a base case and what belongs in a downside case?

A base case holds the assumptions a sponsor expects to happen, and that includes unwelcome ones such as a higher exit cap rate. A downside case changes named inputs by a stated amount and carries each linked consequence through the cash flow to the equity result. The test is whether every difference between the two cases traces to a changed input, because a lower return printed beside the base return does not show how it was reached.

A base case is the expected plan, adverse assumptions included

The base case describes what the sponsor expects, and an expectation can include drift the sponsor would prefer to avoid. A rising exit cap rate or a longer lease-up can sit inside it. Its calculated return is a projection and is not guaranteed.

The exit cap rate shows the point most clearly. The entry cap rate is the projected first-year net operating income divided by the acquisition price. The exit cap rate, also called the terminal or reversion rate, is the rate expected at sale. Each is one year of income over a price, so neither measures a return over the hold.

A base case can build the drift in directly, for example a 5.75% exit cap rate that already carries a 10% increase applied on a straight line basis at 2% per year. The rate at sale is set by the market, which the sponsor cannot influence, so a cushion inside the expected case is a deliberate choice about where the stress begins.

The cushion changes what the downside has to do. A downside exit cap rate equal to the base case’s already drifted rate is the base case under a different label. The downside has to go past the point where the base case stops.

The income being capitalized needs a label too. A rate applied to trailing twelve months of income and a rate applied to next year’s projected income give different prices at the same displayed rate, because the numerator differs. Both cases have to use one convention, or the price difference mixes a rate change with a convention change.

“Our base case capitalization rate on exit already assumes a 10% increase in the rate. We do this on a straight line basis and increase the rate 2% per year.”

Why cap rate, discount rate and growth move together in a downside

In a valuation model, the discount rate equals the cap rate plus the rate of change in income. Rearranged, the cap rate equals the discount rate minus growth, and the gap between the two rates widens as growth gets stronger. A downside that cuts growth therefore pushes the supportable cap rate up even if the discount rate never moves.

A sensitivity run on a sample hotel at a constant 5.0% interest rate shows the direction. With net operating income declining at 2.5% a year, the cap rate on trailing income came out at 9.5%. With income growing at 7.5% a year, it came out at 6.5%.

Growth and rates also offset each other. In the same analysis, income growth of 2.5% a year did not make up for a 100 basis point rise in interest rates, while growth of 5.0% a year more than made up for it. A downside that lowers growth and raises rates together removes the offset from both sides.

Hotel valuation scenarios have used an 11% discount rate, 100 basis points above a 10% base case, to reflect a higher cost of capital during a disruption. Raising the discount rate alone, with growth left at the base figure, already implies a higher cap rate. Adding a growth cut and a hand-lifted terminal cap rate on top of that can count one shock several times.

The working rule for any property type is to decide which rate is the driver and let the others follow from the identity. Everything else in the downside case is then a consequence that can be checked.

Development: construction months and the yield spread

Development makes completion timing a modeled variable. A base case that assumes 18 months of construction can be paired with a stress test that adds two months to complete construction.

A schedule extension is one assumption. It moves the start of operations and the date of the first distributions. Whether it also adds interest or overhead depends on the financing and expense lines, and each of those has to be linked to the new date in the downside or it is missing from the result.

The base case also carries a margin between what a project costs to build and what the finished asset trades for. A spread near 200 basis points can arise when a 5.8% to 6.0% development cap rate sits against a trading cap rate below 4.0%, with rents untrended during development.

The spread is the development yield minus the trading cap rate, so anything that moves either number moves the spread one for one. Higher cost narrows it, and so does a higher trading rate. A downside case for development states which of the two it changes and by how much, because the spread alone does not reveal that.

Why compared returns need one fee and promote basis

Returns for the base case and for both the downside and upside cases can each be stated net of fees and promote, or only some of them may be, with the others carrying no such statement. In one fund update, the downside and base returns were expressly net, and the upside figure came with no matching statement.

Net and gross do not move together across scenarios. A promote is paid only when profits clear a hurdle, so in a case that does not clear it, the promote is zero and gross and net differ only by fees. In a case that clears the hurdle, the promote is paid and the net figure sits further below gross. Scenario returns on mixed bases give a spread that overstates or understates the real range.

A downside that still earns a positive return also carries information. It shows how much the chosen stress left standing, and so how severe the stress was. A reader can ask the reverse question as well, which is how far the inputs have to move before equity distributions fall below the equity invested.

Worked example: a hypothetical $25,000,000 acquisition held for three years

This hypothetical example compares a base case and a downside case on the same capital. The price is $25,000,000 and the interest-only debt is $15,000,000 at 6%. Equity is $25,000,000 minus $15,000,000, or $10,000,000. Debt is $15,000,000 divided by $25,000,000, multiplied by 100, or 60% of price. Fees are ignored in both cases, all cash after interest is distributed each year, and the sale happens at the end of year three.

Annual interest is $15,000,000 multiplied by 6, divided by 100, or $900,000. Year-one net operating income is $1,500,000 in both cases, so the entry cap rate is $1,500,000 divided by $25,000,000, multiplied by 100, or 6%. The exit value in each case capitalizes year-three income.

Base case income is $1,500,000, then $1,560,000, then $1,625,000. The exit cap rate is 6.5%, which is 6.5 minus 6, multiplied by 100, or 50 basis points above entry, so the base case carries drift already. Cash after interest is $1,500,000 minus $900,000, or $600,000, then $1,560,000 minus $900,000, or $660,000, then $1,625,000 minus $900,000, or $725,000. Those sum to $600,000 plus $660,000 plus $725,000, or $1,985,000.

Base exit value is $1,625,000 divided by 6.5%, or $25,000,000. After repaying $15,000,000 of debt, sale proceeds to equity are $25,000,000 minus $15,000,000, or $10,000,000. Total distributions are $1,985,000 plus $10,000,000, or $11,985,000. The gain is $11,985,000 minus $10,000,000, or $1,985,000, which is $1,985,000 divided by $10,000,000, multiplied by 100, or 19.85% of equity over the three years. Debt at sale is $15,000,000 divided by $25,000,000, multiplied by 100, or 60% of value.

The downside holds the price, debt amount, interest rate and hold period fixed and changes two inputs. Income is $1,500,000, then $1,450,000, then $1,400,000, and the exit cap rate is 7%. Cash after interest is $1,500,000 minus $900,000, or $600,000, then $1,450,000 minus $900,000, or $550,000, then $1,400,000 minus $900,000, or $500,000. Those sum to $600,000 plus $550,000 plus $500,000, or $1,650,000.

Downside exit value is $1,400,000 divided by 7%, or $20,000,000, which is $25,000,000 minus $20,000,000, or $5,000,000 below the base value. That drop is $5,000,000 divided by $25,000,000, multiplied by 100, or 20%. Sale proceeds to equity are $20,000,000 minus $15,000,000, or $5,000,000. Total distributions are $1,650,000 plus $5,000,000, or $6,650,000, and the loss is $10,000,000 minus $6,650,000, or $3,350,000. That is $3,350,000 divided by $10,000,000, multiplied by 100, or 33.5% of equity.

Debt at sale is $15,000,000 divided by $20,000,000, multiplied by 100, or 75% of value, against 60% in the base case. Operating cash stayed positive every year, yet equity lost a third of its capital because the same debt sat under a lower sale value. In the base case the sale price equals the purchase price, since income growth and the higher exit cap rate offset each other.

Mistakes that make base and downside cases misleading

Holding the exit cap rate at the base figure while cutting income growth breaks the identity that links the two. The cap rate equals the discount rate minus growth, so lower growth at a constant discount rate implies a higher cap rate. In the hotel sensitivity at a constant 5.0% interest rate, a 2.5% annual decline in income carried a 9.5% cap rate on trailing income, against 6.5% at 7.5% annual growth. A downside with weak growth and a base exit rate describes two incompatible markets.

Layering a higher discount rate, a growth cut and a higher terminal cap rate can count a single shock more than once. A 100 basis point rise in the discount rate already moves the cap rate unless growth moves with it. Correct treatment names the driver, applies it once and lets the linked rates follow.

Comparing returns on mixed bases misstates the range. A downside quoted net of fees and promote beside an upside with the basis left unstated makes the gap between cases larger or smaller than it is. Each scenario return needs the same fee and promote treatment before the spread means anything.

A cap rate is one year of income over a price. It does not measure a return over the hold, and it carries no information about the debt or the exit. In the example the entry cap rate is 6%, while the three-year equity result is a gain of 19.85% in the base case and a loss of 33.5% in the downside.

Treating a schedule extension as the whole construction stress leaves out its costs. Two extra months on top of 18 moves completion, but carrying interest and delayed income appear only if each is linked to the new date. If a separate cost overrun is also stressed, the same carrying cost can enter twice.

Checklist questions for reading a base case and downside pair

Which adverse assumptions are already inside the base case? A drifted exit cap rate or a longer schedule sets the starting point that the downside has to exceed.

Is the downside exit cap rate above the base exit cap rate? A downside rate equal to the base rate leaves the sale price unstressed.

Which income is being capitalized in each case? Trailing and forward income give different prices at the same displayed rate.

Do growth, discount rate and cap rate agree with each other? Because the discount rate equals the cap rate plus the rate of change, a change to one implies a change to another.

Are all returns net of the same fees and promote? Mixed bases distort the distance between the scenarios.

Is the capital structure identical across the cases? A different debt amount or distribution timing adds a second cause to the difference in results.

Does a schedule delay flow into interest and overhead? A moved completion date with unchanged costs describes a narrower stress than the label suggests.

How far can the inputs move before equity distributions fall below equity invested? That break-even distance shows more about severity than a single downside return.

Is the development spread stated as yield minus trading rate, with each side visible? A spread of around 200 basis points can narrow from either end.