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 get 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.
- The terminal capitalization 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 NOI divided by the purchase price of the property.
- If this 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 net operating income (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, keeping in mind that it may be a safer test for the development to nudge the terminal cap rate up a bit. 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 to investors.
Savvy 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 that the net operating income will not decrease over the holding period. Some of the data that must be considered includes supply-and-demand metrics for each category of space, as well as for the services and expenses assumed to be 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 thus critical that all real estate investors compile and analyze as much data as possible to accurately pinpoint a terminal capitalization rate for a project.
Example of the Terminal Capitalization Rate
An investor buys a fully occupied property for $100 million. First-year NOI is estimated at $5.0 million. The going-in cap rate is therefore 5.0%. Seven years later, the investor believes that the terminal capitalization rate is approximately 4.0%. Last-year NOI, which has taken into account rent escalation along the way, is projected at $5.5 million (again, assuming full occupancy). The resale value is estimated at $137.5 million ($5.5 million in NOI divided by the 4.0% terminal capitalization, or exit, rate).