Terminal Cap Rate Calculator
What is a Terminal Cap Rate?
The Terminal Cap Rate (also known as the Exit Cap Rate or Reversionary Cap Rate) is a critical metric used in commercial real estate financial modeling. It represents the projected rate of return an investor expects to receive at the end of an investment holding period when the property is sold.
Unlike the "Going-In Cap Rate," which is determined by the current purchase price and current NOI, the Terminal Cap Rate is a future assumption used to calculate the Terminal Value (resale price) of the asset.
How to Calculate Terminal Cap Rate
The calculation assumes a direct relationship between the Net Operating Income (NOI) of the property and its market value at the time of sale. The formula is:
Terminal Cap Rate = (NOI in Year n+1) / Projected Sale Price
Where:
- NOI (Year n+1): The projected Net Operating Income for the 12 months immediately following the sale.
- Projected Sale Price: The estimated reversion value of the property at the exit year.
Real World Example
Imagine you are analyzing a multifamily apartment complex with a 5-year holding period:
- You project that in Year 6 (the year after sale), the property will generate a Net Operating Income (NOI) of $150,000.
- Based on market trends, you estimate the property will sell for $2,500,000.
- Using the calculator above: $150,000 / $2,500,000 = 0.06 or 6.00%.
This 6.00% is your Terminal Cap Rate. In a Discounted Cash Flow (DCF) analysis, this rate is often estimated first (e.g., usually 50-100 basis points higher than the going-in rate) to derive the projected sale price.
Why is the Terminal Cap Rate Higher?
Investors typically project a Terminal Cap Rate that is higher than the entry cap rate (a concept known as "expansion"). This accounts for:
- Asset Aging: The building will be older at the time of sale, potentially requiring more capital expenditures.
- Market Uncertainty: Forecasting 5 to 10 years into the future carries inherent risk.
- Functional Obsolescence: Newer properties may enter the market, making the subject property less competitive.
A conservative financial model might assume an entry cap rate of 5.0% and a terminal cap rate of 5.5% or 6.0%.