What Is the Terminal Capitalization Rate?
Let me explain the terminal capitalization rate, which you might also hear called the exit rate. It's the rate we use to figure out what a property could sell for at the end of the time you're planning to hold it. You take the expected net operating income (NOI) for that final year and divide it by the terminal cap rate, which is a percentage, to arrive at the terminal value.
When estimating these rates, we rely on data from similar property transactions or what's considered right for the property's specific location and features.
Key Takeaways
- The terminal capitalization rate, or exit rate, helps 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.
- If the terminal capitalization rate is lower than the going-in rate, it usually signals that the property investment was profitable.
Understanding the Terminal Capitalization Rate
You need to understand how the going-in cap rate works in comparison. It's simply the projected first-year NOI divided by what you paid for the property initially. On the other hand, the terminal capitalization rate takes the projected NOI from the last year—the exit year—and divides it by the eventual sale price. If this terminal rate ends up lower than your going-in cap rate, that's a good sign the investment paid off.
Most pros in real estate investing will tell you it's crucial to align the terminal capitalization rate with what's happening in the current market. That said, for safety in your development projects, consider bumping up the terminal cap rate a little. A dynamic spreadsheet is a great tool here—use it to stress test your project and find the highest terminal cap rate that still delivers enough return for investors.
If you're a smart investor, you'll target markets and property types where cap rates are likely to drop over time. A lower terminal cap rate compared to the going-in one means capital gains, as long as the NOI holds steady or grows during the holding period. Make sure to factor in supply-and-demand data for different space categories, plus the services and expenses tied to each operational area.
Important Considerations
Remember, the future is unpredictable, but two things are guaranteed at the end of any holding period: your buildings will have aged, and the markets will have shifted. That's why, as a real estate investor, you must gather and analyze as much data as you can to nail down an accurate terminal capitalization rate for your project.
Example of the Terminal Capitalization Rate
Here's a straightforward example to show you how this works. Suppose an investor purchases a fully occupied property for $100 million, with the first-year NOI estimated at $5.0 million. That gives a going-in cap rate of 5.0%.
Fast forward seven years, and the investor estimates the terminal capitalization rate at about 4.0%. The NOI for that last year, accounting for rent increases and assuming full occupancy, is projected at $5.5 million.
So, the resale value comes out to $137.5 million—that's $5.5 million in NOI divided by the 4.0% terminal cap rate, or exit rate.
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