What Is the Terminal Capitalization Rate?
The terminal capitalization rate, also known as the exit rate, is the rate used to estimate the resale value of a property at the end of the holding period. The expected net operating income (NOI) per year is divided by the terminal cap rate (expressed as a percentage) to derive the terminal value.
Terminal capitalization rates are estimated based on comparable transaction data or what is believed to be appropriate for a particular property’s location and attributes.
Key Takeaways
- The terminal capitalization rate, or exit rate, is used to estimate the resale value of a property at the end of the holding period.
- The going-in cap rate is the property’s projected first-year net operating income divided by the purchase price of the property.
- If the terminal capitalization rate is lower than the going-in rate, it usually means that the property investment was profitable.
Understanding the Terminal Capitalization Rate
The going-in cap rate is the projected first-year NOI divided by the initial investment or purchase price. In contrast, the terminal capitalization rate is the projected NOI of the last year (exit year) divided by the sale price. If this rate is lower than the going-in cap rate, it usually means that the property investment was profitable.
Most real estate investing professionals agree that it’s important to match the terminal capitalization rate to the current rate of the market, with the possibility of slightly adjusting it for safety. A dynamic spreadsheet can be useful to stress test the development project to establish the highest terminal capitalization rate that would still provide a sufficient upside for investors.
Astute real estate investors look for markets and property types for which market capitalization rates are expected to fall since a lower terminal capitalization rate, compared to the going-in cap rate, will result in capital gains, assuming the NOI does not decrease over the holding period. Some of the data to consider includes supply-and-demand metrics for each category of space, and for the services and expenses related to each area of operation.
While the future is always uncertain, two things are certain about the end of any holding period: the buildings will age and the markets will change. It’s crucial for real estate investors to compile and analyze as much data as possible in order to accurately determine a terminal capitalization rate for a project.
Inspirational Example of the Terminal Capitalization Rate
An investor buys a fully occupied property for $100 million. The first-year NOI is estimated at $5.0 million, giving a going-in cap rate of 5.0%.
Seven years later, the investor estimates that the terminal capitalization rate is around 4.0%. The last year’s NOI, accounting for rent escalation, is projected at $5.5 million, assuming full occupancy.
Based on these figures, the resale value is estimated at $137.5 million ($5.5 million NOI divided by the 4.0% terminal capitalization rate).
This example highlights how understanding the terminal capitalization rate can significantly impact an investor’s projections and decision-making process in real estate deals.
Related Terms: going-in cap rate, net operating income, holding period, capital gains, real estate market trends.
