Definition
The terminal cap rate (also called the exit cap rate) is the capitalization rate an investor assumes when estimating a property’s resale value at the end of the hold period. It converts a future year’s projected NOI into an implied sale price.
How It’s Used
In most models, the sale price is estimated by dividing the stabilized NOI in the sale year by the terminal cap rate:
Common formula
- Estimated Sale Price = Projected NOI in Sale Year ÷ Terminal Cap Rate
Why It Matters
The terminal cap rate is often one of the largest drivers of IRR because a small change in cap rate can meaningfully change the exit value. A lower terminal cap implies a higher sale price (more optimistic), while a higher terminal cap implies a lower sale price (more conservative).
How Investors Choose a Terminal Cap Rate
There is no perfect answer—terminal cap selection is a judgment call based on property quality, market risk, interest rates, and where the asset sits in the cycle. Common approaches include:
- Use market evidence: start with current cap rate comps for similar stabilized assets.
- Apply a “cap rate expansion†cushion: assume the exit cap is higher than the entry cap (e.g., +25 to +100 bps) to bake in conservatism.
- Match the hold-period risk: longer holds often justify more uncertainty and a higher exit cap assumption.
- Account for asset quality: stabilized, well-located assets may trade at lower caps than transitional assets.
- Stress test the spread: run sensitivities on exit cap to see how fragile returns are.
Example
A property is projected to generate $1,200,000 of NOI in year 5. If the terminal cap rate is 5.50%, the estimated sale price is:
- Sale Price = $1,200,000 ÷ 0.055 = $21,818,182 (approx.)
If the terminal cap is increased to 6.00%, the sale price becomes:
- Sale Price = $1,200,000 ÷ 0.060 = $20,000,000
A 50 bps increase reduces the exit value by about $1.82M—often enough to materially change IRR.
Common Pitfalls
- Using an unrealistically low exit cap: can “manufacture†returns that aren’t supported by risk.
- Ignoring capex at exit: sale-year NOI may overstate value if major deferred maintenance remains.
- Confusing going-in vs. going-out: entry pricing reflects today’s market; exit pricing reflects a future market.
- Not adjusting for stabilization: a transitional asset may not merit a tight cap without proven NOI quality.
- Failure to run sensitivities: exit cap risk should be explicitly stress-tested.