What Exit Cap Rate Should a Syndication Assume?

No rule sets the exit cap rate a syndication must assume, but a cautious model assumes it at or above the going-in cap rate, explains why, and shows what happens to returns across a range of exit cap rates. The exit cap rate turns the final year's net operating income into a sale price, so a half-point change can swing the investors' share of sale proceeds by a large amount. When you read projections, look for the assumption, the reasoning and a sensitivity table.

What is the exit cap rate?

The cap rate is NOI divided by price. At purchase it is the going-in cap rate; at sale it is the exit (or terminal, or reversion) cap rate. In a model, the sponsor picks an exit cap rate and divides the projected NOI by it to get a sale price. See what is a good cap rate for how cap rates relate to risk and interest rates.

Because price equals NOI divided by the cap rate, the exit cap sits in the denominator. A lower cap rate means a higher price, and the effect grows as cap rates get smaller.

Why do models usually assume a higher exit cap?

A few reasons push careful sponsors to assume an exit cap at or above the going-in rate:

The building will be older. A buyer in year five sees a building five years older, with older roofs and systems.
Rates can rise. Cap rates tend to move with borrowing costs and the yields buyers can earn elsewhere, such as the 10-year Treasury yield, though not one for one.
Projected NOI already includes growth. Assuming both higher NOI and a lower cap rate counts the same optimism twice.

None of this means cap rates cannot fall. They can. The point is that a model should not depend on it. If a sponsor assumes a lower exit cap rate, ask what has to happen in the market for that to be true.

Is there a standard spread?

No regulation or industry body sets one. Some sponsors add a fixed amount, such as 0.10 percentage points for each year of the hold, to the going-in rate. Others use the current market cap rate for similar buildings that are as old as the property will be at sale. Either approach is a judgment. What matters is that the projections state the assumption and the reasoning.

For SEC-registered offerings, the SEC's guidance on projections says management "must have a reasonable basis" for them (17 CFR 229.10(b)). That guidance is written for registered filings, not private placements, but it is a fair standard to hold any projection to. Private offerings remain subject to the antifraud rule in Rule 10b-5.

How much does the exit cap rate change returns?

A made-up example. A sponsor buys a building for $11,000,000 at a 6.0% going-in cap rate on $660,000 of NOI, raising $4,000,000 of investor equity. The model projects $800,000 of NOI at the end of year five, when the loan balance will be $7,800,000. Selling costs are assumed at 2% of price.

Exit cap rate	Sale price	Selling costs (2%)	Net to equity after loan	Net to equity / $4,000,000 raised
5.5%	$14,545,455	$290,909	$6,454,546	1.61x
6.0%	$13,333,333	$266,667	$5,266,666	1.32x
6.5%	$12,307,692	$246,154	$4,261,538	1.07x
7.0%	$11,428,571	$228,571	$3,400,000	0.85x

Net to equity is sale price minus selling costs minus the $7,800,000 loan payoff. The last column covers sale proceeds only, before any distributions during the hold and before the sponsor's promote, so it is not the deal's equity multiple. Going from a 6.0% to a 7.0% exit cap cuts net proceeds from $5,266,666 to $3,400,000, about 35% less, even though NOI grew by more than 20% over the hold.

How do you stress test the exit cap?

Find the break-even exit cap. At what exit cap rate do investors get back exactly their capital from the sale? In the example, net proceeds equal $4,000,000 when the sale price is about $12,040,816, which is an exit cap rate of about 6.64%.
Cross it with rent growth. A two-way table of exit cap and annual rent growth shows whether the deal depends on both going right. See rent growth assumptions.
Check the loan. A prepayment premium or a refinance at a higher rate changes the result as well. See prepayment penalties.
Compare to today. If the exit cap is below the cap rates of recent sales of similar older buildings, ask why.

How DoorRaise fits in

DoorRaise helps sponsors raise equity for apartment buildings with 5 or more units under Rule 506(b) or 506(c). It prepares the standard offering documents, files Form D and state notices, and holds investor funds in escrow at Enterprise Bank & Trust, an FDIC-insured bank. DoorRaise does not set or approve a deal's assumptions; the exit cap rate in a deal's projections is the sponsor's, and investors should test it.

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FAQ

Should the exit cap rate always be higher than the going-in cap rate?

Not always, but a model that assumes a lower one should explain why. An exit cap at or above the going-in rate is the cautious starting point.

What is a reversion cap rate?

Another name for the exit cap rate: the rate used to value the property at the end of the hold.

Which NOI is divided by the exit cap rate?

Models differ. Some use the final year's NOI, others the next year's projected NOI, which a buyer would underwrite. Ask which one the model uses, because it changes the price.

Does the exit cap rate matter if the plan is to refinance, not sell?

Yes. A lender sizes a new loan on value, and value depends on the cap rate the appraiser uses.

Next step: read syndication target returns to see how the exit assumption feeds the headline numbers.

Sources

This article is general information, not legal, tax or investment advice. Talk to your own securities attorney or financial adviser before you invest. DoorRaise is not a law firm, broker-dealer, investment adviser or funding portal.