Going-In vs Exit (Terminal) Cap Rate

Most first-time buyers treat the going-in cap rate as the number that tells them what they will earn, and the exit cap rate as a guess they can ignore until it is time to sell. Both habits are wrong. The going-in cap rate is only the yield on the day you buy. The exit cap rate is the single assumption that decides whether your total return, the thing you actually keep, beats a bond fund or lands below it. Set one number in a pro forma, set the exit cap rate. Pick it, test it, and understand why the market punishes a lazy guess more than it punishes a wrong rent projection.

A cap rate is the ratio of a property's net operating income (NOI) to its price, expressed as a percentage. If a building earns $100,000 in NOI and sells for $1,000,000, the cap rate is 10%. That is the whole identity, and it will not change. The going-in cap rate uses the price you pay today and the NOI you expect in the first year. The exit cap rate, also called the terminal cap rate, uses the expected resale price at the end of your holding period and the NOI in the year after you sell. The formal definition in appraisal work is exit year NOI divided by expected resale price, or, taken from the buyer's side, first-year NOI after sale divided by net sale proceeds. The reversion cap rate is the same idea under another name: it is the rate applied to the reversion, the property's value at the end of your ownership. In a discounted cash flow model, the reversion cap rate is the last assumption before you press calculate, and the one most people fudge.

Here is what trips up students who have just met the formula. The cap rate is a yield, not a return. It ignores appreciation, capital expenditures, and the cost of debt. A property with a 5% cap rate can deliver a 0% total return if rents stay flat and the exit cap rate rises, or a 10% return if rents grow and the exit cap rate falls. The distinction between yield and return comes straight out of Geltner et al.'s Commercial Real Estate Analysis and Investments, the standard graduate text. The cap rate is also unlevered: it measures the property's income before any mortgage payment. Your cash-on-cash return, what lands in your pocket after debt service, is a different animal. A high cap rate with high debt can produce a negative cash-on-cash return if the loan costs more than the yield. Never quote a cap rate to a lender as if it were your return. They will correct you once, and then they will not call back.

The going-in cap rate is easy to verify because you are setting the price. The exit cap rate is a forecast, and that is where the discipline lives. Appraisers use the reversionary method for the terminal cap rate: they apply it to the projected NOI in the year after the holding period, and they derive it from comparable sales of similar properties at the assumed exit date. The Appraisal Institute's The Appraisal of Real Estate, 15th edition, is the source for this convention, and it typically runs 50 to 100 basis points above the market cap rate at the valuation date. You will see that spread in lender underwriting standards too, which is why the exit cap rate is not a negotiable opinion. It is a covenant.

Why the Exit Cap Is Usually Set Above the Going-In Cap

The exit cap rate is almost always higher than the going-in cap rate, and there is a reason that is not pessimism. The exit yield must compensate the next buyer for risk and the time value of money. You are asking someone to pay for a stream of income that starts a decade from now, and a lot can happen between now and then: interest rates move, tenants leave, and the building ages. A higher cap rate at exit means a lower resale price, which is how the market builds in that uncertainty. Geltner et al. make this point directly: the exit yield must compensate for risk and time value, so the terminal cap rate sits above the going-in rate.

The size of that gap depends on what you are buying. In a stabilized, low-growth market, underwriters typically pencil the terminal cap rate 50 basis points above the going-in rate. In a value-add deal in a high-growth market, the gap widens to 100 to 200 basis points, because the income is riskier and the projected growth is less certain. Lender guidance for commercial mortgages falls in a similar range: 25 to 100 basis points above the going-in rate in a normal deal, and 150 to 200 basis points in a stressed case. The stressed case is not a scare story; it is the scenario the lender uses to check whether the property can absorb a shock. If your exit cap rate is below the lender's stressed number, your equity is thinner than you think.

A common failure mode is to use the same cap rate for entry and exit because the property looks stable. That is how you manufacture a false profit. If you buy at a 6% cap rate and sell at a 6% cap rate, the only way to make money is if NOI grows faster than the market expects. The moment the exit cap rate moves to 7%, your resale price drops by roughly 14%, and that wipes out several years of cash flow. The asymmetry is brutal: a 100 basis point improvement in the going-in cap rate helps you, but a 100 basis point deterioration in the exit cap rate hurts you similarly because it applies to a larger price base.

Sale Price from the Exit Cap Rate: A Worked Example

Here is the arithmetic you will do a hundred times. Suppose you buy a building with $100,000 in year-one NOI. You hold it for five years, and you project NOI grows at 3% per year. At exit, year-six NOI is $115,927, which is $100,000 times 1.03 to the fifth power. Now apply the exit cap rate. If the terminal cap rate is 7%, the resale price is $1,656,100. If the terminal cap rate is 8%, the resale price is $1,449,088. The difference is large on a property you bought for about $1.67 million at a 6% going-in cap rate. That single 100 basis point move in the exit cap rate is larger than the total cash flow you collected in year one.

Notice what is not in that calculation: the exit cap rate is not a growth rate, and it is not a discount rate. It is a divisor. A lower exit cap rate inflates the resale price, which is why buyers who plan to flip quickly are tempted to pencil a low one. Resist that temptation. The market will not reward you for assuming the exit cap rate matches the going-in rate unless you are buying a fully stabilized asset in a market with no supply pipeline, and even then, the lender will push back. If you want to test your own discipline, run the same example with a 9% exit cap rate. The resale price drops, and your total return goes negative unless NOI growth was higher than you projected.

The failure case here is using trailing NOI instead of a stabilized, pro-forma number. A seller will quote a pro-forma NOI that assumes full occupancy and market rents, which can be 10% to 20% higher than the actual trailing NOI. If you apply the exit cap rate to that inflated number, you get a resale price that no real buyer will pay. The fix is to rebuild the NOI from the rent roll, not from the brochure. Use the in-place rents, adjust for vacancy and collection loss, and do not let the seller's expense ratio stand if it understates property taxes and insurance, which are the fastest-growing costs. A pro-forma that shows a 5% expense growth rate when taxes are rising at 8% per year is a fantasy.

Sensitivity of IRR to the Exit Cap Rate

Your internal rate of return (IRR) is the levered or unlevered return that ties all cash flows together, and it is far more sensitive to the exit cap rate than to the going-in cap rate. The reason is compounding: the exit cap rate determines the terminal value, which is usually 75% to 85% of the total return in a five-year hold. If you get the exit cap rate wrong by 50 basis points, the IRR moves by about 0.5 to 0.7 percentage points. If you get it wrong by 150 basis points, the deal can go from a 12% IRR to a 9% IRR, which is the difference between a good investment and a bad one. This is why the cap rate vs IRR comparison matters: the cap rate is a snapshot, and the IRR is a movie, but the exit cap rate is the scene that decides the ending.

Build a sensitivity table before you make an offer. In Excel, set up a data table with the exit cap rate on one axis and the NOI growth rate on the other, and compute the IRR for every combination. In Google Sheets, the same What-If analysis works with a simple formula. You are looking for the corner of the table where the IRR falls below your hurdle rate. If that corner is only one cell, the deal has a margin of safety. If the corner covers a quarter of the table, you are buying a lottery ticket. The table is not decoration; it is the difference between a confident bid and a hope.

Do not fall for the trap of using a single point estimate. A pro forma that shows one IRR with no sensitivity analysis is a sales document. The lender will stress your numbers, and the appraiser will check your comps, but you are the only one who will live with the outcome. Run the table with the terminal cap rate 50 basis points above your base case and 100 basis points above. If the deal still clears your hurdle in the stressed case, you can proceed. If it does not, the problem is not the model; it is the price.

Cap Rate Compression and Expansion

Cap rate compression is what happens when prices rise faster than NOI, pushing the cap rate down. Cap rate expansion is the opposite: prices fall relative to income, pushing the cap rate up. The market moves between these two states all the time, and the direction is not random. When interest rates fall, cap rates tend to compress because the cost of capital drops and buyers can accept lower yields. When rates rise, cap rates expand, and property values fall. The 10-year Treasury is the closest thing to a floor for cap rates on income-producing real estate, and the spread between the two is where the risk premium lives.

The mistake is assuming that cap rate compression is a permanent feature of the market. It is not. In the mid-2020s, cap rates expanded sharply as the Federal Reserve raised rates, and assets that had traded at 4% caps repriced to 5.5% or 6%.The lesson is not to predict the next move; it is to build a model that survives being wrong. If your exit cap rate assumption is a full 100 basis points higher than the going-in rate, you have already priced in a moderate amount of cap rate expansion. If you use the same rate for both, you are betting that the market never reprices, and that is a bet against history.

The interaction between the going-in cap rate and the terminal cap rate is the whole game. A low going-in cap rate on a stable asset can be a better investment than a high cap rate on a risky one, because the stable asset has a lower risk of cap rate expansion at exit. The opposite is also true: a high going-in cap rate that looks like a bargain can turn into a value trap if the exit cap rate expands. This is why the cap rate vs IRR distinction matters in practice. The cap rate tells you the yield today; the IRR tells you the return over time; and the exit cap rate is the bridge between the two. Ignore the bridge and you will fall.

Frequently Asked Questions