The exit cap rate is the assumption that moves everything

Every projection ends with a sale. To model that sale, someone has to guess what a buyer will pay years from now. That guess is the exit cap rate, and it usually gets one line in a summary.

A cap rate is the yield a buyer accepts on a property's income. Divide the annual net operating income by the price and you have it. Run it backwards and you have the valuation method: income divided by cap rate equals value. A lower cap rate means a higher price for the same income.

Here is why the exit assumption dominates. This is an illustration, not a real deal. A property is bought at a five percent cap with net operating income of $500,000, which puts the price at $10,000,000. The plan raises income to $650,000 over five years through renovation and better operations. Real work, real improvement.

Sell at that same five percent cap and the property is worth $13,000,000. Sell at six percent and it is worth $10,833,333. The operating plan succeeded completely in both cases. The difference between them is $2,166,667, and it came entirely from a number nobody controls.

Now put a loan against it. Say the original loan was $6,500,000. At the five percent exit, equity is $6,500,000 against $3,500,000 invested. At the six percent exit, equity is $4,333,333. The first case nearly doubles the money. The second returns about a quarter more than was put in. Same building, same rent growth, same management.

This is the reason a conservative sponsor underwrites the exit cap above the entry cap. Assuming you will sell at a worse yield than you bought at is not pessimism. Cap rates move with interest rates and sentiment. A five year forecast of either is not really a forecast.

A projection that assumes the exit cap equals the entry cap is quietly assuming the market does you no harm. A projection that assumes a lower exit cap is assuming the market does you a favour, and is borrowing from that favour to make the return look better today.

Three questions. What exit cap did you underwrite, and how does it compare to the cap rate we are buying at? What does the return look like if the exit cap is fifty basis points higher than your assumption? At what exit cap does this deal return exactly the capital invested and nothing more?

The third number is the real margin of safety, and it is a single figure that any sponsor can produce in a minute.

Value created by operations is yours. Value created by cap rate movement is weather.

In the last projection you read, was the exit cap higher than the entry cap, and did anyone say why?