The term exit cap rate or terminal cap rate refers to the capitalization rate used to calculate the resale value of a property by capitalizing the expected net operating income of the property at the end of the planned holding period.
In this sense, and strictly speaking, the analyst needs to forecast what the prevailing local market capitalization rate will be for the property type represented by the property under consideration at the expected time of resale and then adjust it accordingly depending on how the property examined deviates from market average. With an exit cap rate forecast at hand, then the property resale price in the last period (n) of the investment horizon can be calculated as:
Resale price(n) = NOI(n)/Exit Capitalization Rate
Historical cap rate data for the property type and market under consideration can help the analyst establish some realistic ranges within which market capitalization rates can move, and then use exit cap rates within this range to run some sensitivity analysis to determine a realistic low and high resale price that can be attained by the property.
Exit Cap Rates vs Entry Cap Rates
Entry or going-in cap rate is the rate represented by the price at which the property is acquired. As such it is calculated as:
Entry Cap Rate = NOI / Acquisition price
As indicated by the formula above, the entry cap rate equals the ratio of the NOI of the property at the time of purchase over the acquisition price.
Typically, when analyzing a property, investors assume an exit capitalization rate that is higher than the entry cap rate by 0.5-1 percentage points to account for the uncertainty of future cash flows expected to be received by the property under consideration over the holding period. This sounds like a prudent practice to account for the uncertainty of the future state of the market, however, such an assumption may not reflect the true path of cap rates over the investment holding period. That is why the investor can make more accurate predictions of the most likely resale price, if reliable forecasts of future cap rates are available.
Forecasting Exit Cap Rates
Empirical analysis of cap rate influences indicates that cap rate movements are strongly affected by movements in the local property market and interest rates. Advanced econometric analysis of historical cap rate data by market and property type can help develop forecasting equations for market (exit) capitalization rates. In particular, historical cap rate data can help calibrate (estimate the parameters) of econometric equations that can then be used in combination with forecasts of local market indicators such as rent growth, price growth, interest rates and other variables to forecast the path of cap rates.
Historical data of sufficient length are necessary for developing such forecasting equations. This is feasible only for the largest markets for which reliable historical data are available from vendors. When using such historical cap rates the analyst needs to have in mind that there are measurement issues that need to be clarified and understood. These measurement issues are discussed in the article historical cap rates