Worked example: exit cap rate widens at sale
A wider exit cap rate lowers the price a buyer pays for the same NOI, and because the loan payoff and the dollar equity base do not move, the loss falls on equity at a much higher percentage than the drop in value. In the hypothetical below, a 150 basis point wider exit cap cuts the sale price by 20 percent and cuts equity receipts by an amount equal to 49 percent of contributed equity. A deal that returns 1.20x at the base exit cap returns 0.71x at the stressed one, with operations identical in both cases.
Why a wider exit cap cuts price while income stays put
The entry cap rate is projected first year NOI divided by the acquisition price. The exit cap rate, also called the terminal or reversion cap rate, is the expected capitalization rate at sale. Both are one year of income over a price. Neither measures a return over the hold.
Sale value is the NOI a buyer capitalizes divided by the exit cap rate. With income fixed, a larger cap rate gives a smaller value, and nothing about the building has to change for that to happen.
The same relation read backward shows the cost of the move. A building worth $2 million at a 6% cap rate produces $120,000 of NOI, and at an 8% cap rate it produces $160,000. Holding a $2 million value through that shift would take $160,000 of NOI in place of $120,000.
Expansion needs a reference point. Measured from the entry cap, it is the gap between acquisition pricing and assumed sale pricing. Measured from the base exit cap, it is an extra stress layered on a forecast that may already include some widening. Both get called cap rate expansion, so a model that reports only a single number leaves the reader unsure which gap it describes.
“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.”
How much widening underwriting builds in
Published assumptions for exit cap drift span a wide range. One is 50 basis points over a five year deal. Another is 100 basis points over a ten year hold. A third is a band of 100 to 150 basis points between purchase and sale.
Another approach drifts the market cap rate up 2% per year through the first five years, which is a straight-line 10% increase in the rate. One base case that follows this convention shows a 5.75% exit cap rate that already carries the 10% increase.
Widening that was underwritten has not always arrived. In one case the underwritten 100 to 150 basis points of expansion met a market where cap rates tightened during ownership.
Rating criteria add a different yardstick. Loan specific cap rates there are typically more than 200 basis points above the actual cap rate of the loan, and a cushion of up to 200 basis points is maintained where they are not.
Sparse transactions make the choice harder. Fewer comparable sales weaken a sales comparison approach, and shifts in expectations for interest rates feed into discount rates and exit cap assumptions.
Which NOI the buyer is capitalizing
The cap rate and the NOI are a matched pair. A cap rate quoted on projected first year NOI and a cap rate quoted on historical NOI describe different numerators over the same price.
In one hotel study, going-in cap rates on projected first year NOI ran 20 to 90 basis points above cap rates on historical NOI, because the projected figure reflects expected growth. A band that wide is as large as the base case widening many underwriting models assume.
A spread between entry and exit caps can therefore come from a change in income convention. Reading it as a pricing view requires the same NOI definition on both ends.
The worked example below fixes terminal NOI at one number in both cases so the only moving part is the cap rate.
Worked example: a 150 basis point wider exit cap on a $10 million acquisition
The hypothetical acquisition costs $10,000,000 with projected first year NOI of $550,000 and $6,000,000 of interest-only debt. Both cases cover the same five annual periods, with cumulative operating distributions to equity of $1,000,000. Selling costs are 2% of gross sale value, the loan balance at sale is $6,000,000, and there are no further equity contributions.
Entry cap rate is $550,000 divided by $10,000,000, multiplied by 100, which equals 5.5%. The debt is $6,000,000 divided by $10,000,000, multiplied by 100, or 60% of price. Initial equity is $10,000,000 minus $6,000,000, or $4,000,000.
Terminal NOI is $600,000 in both cases, which is $600,000 minus $550,000, or $50,000 above the first year figure. The base exit cap is 6%, which is 50 basis points of expansion from entry. The stressed exit cap is 7.5%, which is 200 basis points from entry and 150 basis points above the base exit cap.
Base case: gross sale value is $600,000 divided by 6, multiplied by 100, or $10,000,000. Selling costs are $10,000,000 multiplied by 2 and divided by 100, or $200,000. Proceeds after selling costs are $10,000,000 minus $200,000, or $9,800,000. After the $6,000,000 payoff, sale proceeds to equity are $3,800,000. Adding the $1,000,000 of distributions gives total equity receipts of $4,800,000, an equity multiple of $4,800,000 divided by $4,000,000, or 1.2x. Profit to equity is $4,800,000 minus $4,000,000, or $800,000.
Stressed case: gross sale value is $600,000 divided by 7.5, multiplied by 100, or $8,000,000. Selling costs are $8,000,000 multiplied by 2 and divided by 100, or $160,000. Proceeds after selling costs are $8,000,000 minus $160,000, or $7,840,000. After the same $6,000,000 payoff, sale proceeds to equity are $1,840,000. With the $1,000,000 of distributions, total receipts are $2,840,000, an equity multiple of $2,840,000 divided by $4,000,000, or 0.71x. Equity is short of its contribution by $4,000,000 minus $2,840,000, or $1,160,000, which is 29% of contributed equity.
Reconciling the two cases: gross sale value falls by $10,000,000 minus $8,000,000, or $2,000,000, which is 20% of the base value. Selling costs fall by $200,000 minus $160,000, or $40,000, so equity receipts fall by $2,000,000 minus $40,000, or $1,960,000. Divided by $4,000,000 of contributed equity and multiplied by 100, that is 49%.
The multiple is an aggregate figure. Distribution timing would be needed for an annual return, and neither case supplies it.
What the example shows about debt and the income needed to hold value
The payoff is a fixed dollar amount, so the 20% price drop lands on the equity layer. Debt is 60% of the base sale value, $6,000,000 divided by $10,000,000, but 75% of the stressed value, $6,000,000 divided by $8,000,000, multiplied by 100.
A refinancing or extension at that point faces a higher debt ratio on the same asset.
Income can offset a wider cap, and the example puts a price on that. Holding the $10,000,000 base value at a 7.5% cap takes $10,000,000 multiplied by 7.5 and divided by 100, or $750,000 of NOI. That is $750,000 minus $600,000, or $150,000, above the terminal NOI the model already carries.
The same relation as the $2 million building at a 6% and an 8% cap applies here. Every point of cap rate widening has to be paid for by a matching increase in income if value is to be preserved.
Common mistakes in exit cap stress testing
Mixing a relative increase with a basis point increase changes the terminal cap. A 10% increase applied to a 5.5% entry cap is 5.5 multiplied by 10 and divided by 100, or 0.55 percentage points, which is 55 basis points. A flat 50 basis points gives a different rate. A drift of 2% per year over five years is 2 multiplied by 5, or 10%, but only if the convention is stated as straight-line and relative.
A switch in NOI convention reads as pricing. Entry caps on projected NOI and exit caps on historical NOI, or the reverse, differ by an amount that can be as large as 20 to 90 basis points in the hotel data. The 50 basis point base widening in the example is inside that band, so a model could show it without any pricing view at all.
Reporting the value decline and stopping there understates the equity effect. The 20% drop in gross value in the example becomes a reduction in equity receipts equal to 49% of contributed equity, because the loan payoff does not scale down and selling costs are only 2% of whatever the price is.
A stress that moves terminal NOI and cap together hides the pricing sensitivity. If the stressed case in the example also raised NOI to $750,000, the value would match the base case and the stress would read as no loss.
An equity multiple is not an annual return, and a cap rate is not a return over a hold. The 0.71x result can arise from many distribution schedules, and the cap rate covers one year of income against price.
Questions for reviewing an exit cap assumption
Which year of NOI is capitalized at sale? The answer fixes what the buyer is assumed to pay for.
Do entry and exit use the same NOI definition? A mismatch puts a change in income measurement inside what looks like a pricing comparison.
Is expansion measured from the entry cap or from a base exit cap? The reference point determines which gap the sensitivity describes.
Is the drift a relative percentage or a number of basis points? Each gives a different terminal rate from the same starting cap.
Does the stressed case hold terminal NOI constant? Moving income at the same time blends an operating sensitivity into the pricing stress.
How do selling costs and the loan payoff change between cases? A percentage cost shifts with price while a payoff stays fixed in dollars.
What debt ratio does the stressed sale value imply? A higher ratio at exit bears on refinancing and extension terms.
Which other assumptions sit beside the exit cap in the underwriting file? Rental growth, lease-up vacancy, capital expenditure and refinancing each shape the terminal NOI and the exit.