Demystifying Exit Cap Rates: The Most Misunderstood Variable in Real Estate Underwriting
When projecting the future value of a commercial real estate asset, few assumptions carry more weight—or more risk—than the exit cap rate. This single figure can swing your valuation up or down by millions, affect investor internal rates of return, and ultimately determine whether a deal appears to be a grand slam or a dud.
However, despite its importance, exit cap rate assumptions are often treated with surprising nonchalance. Some sponsors apply a generic 10-basis-point increase per year without thinking twice. Others overfit models to an optimistic forecast of future market conditions, failing to gut-check whether that forecast is defensible today.
In this deep dive, we will break down the multiple layers of assumptions embedded in exit cap rate underwriting—starting with the net operating income (NOI) input, then moving to cap rate projections, and finally, exploring how to create a supportable valuation in today's volatile market.
The First Trap: Misunderstanding the NOI Basis
Before you even touch the cap rate, you need to define the Net Operating Income (NOI) figure you are capitalizing. And here is where many otherwise sophisticated models start to wobble. The issue? Not all NOIs are created equal.
Trailing vs. Forward NOI
Trailing NOI uses historical data—typically the last 12 months (T12).
Forward NOI projects future performance, often based on pro forma rents, occupancy, or operational improvements.
On the surface, trailing NOI feels conservative—it reflects what the asset has actually produced. Forward NOI can feel aggressive, as it relies on projections. However, both have their uses.
The real risk comes when a sponsor claims to use one, but actually uses a hybrid—such as annualizing just a few months of forward-looking performance. That can be misleading.
Annualized vs. Full-Year Figures
Let us say your asset just stabilized with a 95 percent occupancy rate, but it has only been that way for three months. If you annualize those three months to get NOI, you are assuming those conditions persist for a full year—which might not be realistic.
Best practice: Use a full 12-month NOI figure, whether historical or projected, and be transparent about the underlying assumptions.
Are Taxes Reassessed?
Many sponsors neglect to account for property tax reassessments post-sale. In some jurisdictions, taxes can jump significantly based on the purchase price—cutting deeply into NOI. If your exit model assumes a $10 million valuation with no tax reassessment, your valuation may be artificially inflated.
Pro tip: Forecast taxes as if the next buyer will also face a reassessment. That is what most sophisticated buyers will do—and it aligns your model with market reality.
Capital Reserves: In or Out?
Another common NOI mistake: excluding capital reserves.
While reserves do not hit GAAP NOI, they do affect cash flow and are often considered in underwriting. Some buyers capitalize cash flow after reserves, others before. The difference can swing your valuation materially.
Rule of thumb: If you are presenting an internal rate of return to investors based on post-reserve cash flows, use that same NOI when backing into the exit valuation. Consistency is key.
NOI Quality: Is It Sponsor-Specific?
Here is a subtle one: not all NOI is market-normalized.
If a sponsor runs a super-lean operation and drives NOI up by cutting costs, that may not be sustainable for a new buyer. Conversely, if your NOI is low due to underperformance, your model may understate the future value.
Ask yourself: Would a market-average buyer achieve the same NOI? If not, adjust accordingly.
Enter the Cap Rate: Where Art Meets Science
Once your NOI is squared away, it is time to apply a cap rate. Here is where things get philosophical—and where most underwriting either becomes too simplistic or too speculative.
The “Conventional” Approach
The common method goes like this:
Take the current market cap rate, then expand it by 5–10 basis points per year over the hold period.
This creates a buffer in your valuation. It assumes that markets will soften over time—either due to rising interest rates, risk-off sentiment, or a return to mean after a peak.
So if today’s cap rate is 5.00 percent and you plan to sell in five years, your exit cap rate might be 5.25 percent–5.50 percent.
This makes intuitive sense—especially in a rising rate environment or when you are buying near a market peak.
Pros:
Conservative and defendable
Aligns with investor expectations
Easy to explain
Cons:
Oversimplified
Does not reflect specific asset or market dynamics
The “Market Forecast” Approach
Some sponsors try to project where the cap rate will be based on future market conditions—looking at interest rate forecasts, market cycle theory, or even construction pipelines.
While this can be intellectually satisfying, it opens the door to confirmation bias. If you are optimistic about the future, you might project lower cap rates, inflating your exit value. However, here is the thing:
Your future cap rate still has to make sense today.
That means even if you believe cap rates will compress, you need to ask: Would a buyer today pay that price? If the answer is no, your model is out of touch.
Context Matters: How Macro Cycles Affect Exit Assumptions
Not all markets behave the same. A one-size-fits-all cap rate expansion will not suffice.
Peak Pricing Periods
During market peaks—such as those seen in late 2021—assets are often priced to perfection. Future returns depend heavily on rents growing and cap rates holding.
In these environments, it is especially important to bake in cap rate expansion. Why? Because any hiccup—rate hikes, recession, softening demand—can crush valuations.
Trough Pricing Periods
In contrast, during downturns or corrections, pricing may already reflect pessimism. Cap rates may already be wider, and buyer sentiment may be cautious.
In these cases, flat or even slightly compressed cap rates may be more realistic—especially if you expect a recovery during your hold period.
Sophisticated underwriting adapts to the cycle.
Stress Testing Exit Valuations
Good underwriting does not stop at a single exit scenario. It includes sensitivity analysis, testing:
Cap rates ±25 basis points
NOI ±10 percent
Tax scenarios (reassessment vs. not)
Hold periods (early exit, delayed exit)
Why does this matter?
Because exit cap rates are one of the least controllable variables in your model. You can improve operations. You can cut costs. However, you cannot control market sentiment or interest rates in year five.
Stress testing reveals the fragility of your returns. And that is a good thing—it helps you build conviction.
Making Your Exit Valuation Supportable Today
Whether you are raising capital or trying to win institutional backing, supportability is the name of the game.
That means:
Benchmark your exit cap rate to today’s market comps.
Show how your NOI compares to market-average performance.
Explain your assumptions clearly—especially taxes and reserves.
Use a range of scenarios, not just a best-case.
When you can defend your exit valuation to a skeptical buyer—or a credit committee—you are in the top decile of sponsors.
Cap Rate Forecasting: A Practical Framework
Still unsure how to build your own methodology? Here is a pragmatic framework:
Start with current market cap rate for similar assets in the same submarket.
Adjust for cycle timing (e.g., peak vs. trough).
Add 5–10 basis points per year of expansion if projecting conservatively.
Layer in market dynamics:
Supply pipeline
Interest rate forecasts
Capital expenditure requirements
Run sensitivities at ±25 basis points
Ask yourself: Could a buyer pay this today?
Final Thoughts: The Real Risk Is Not Being Wrong, It Is Being Overconfident
You cannot predict the future. You can only make reasonable, supportable assumptions. However, many sponsors fall into the trap of precision over accuracy—dialing in their exit cap rate to the hundredth of a percent, while ignoring bigger-picture market risks.
The goal of underwriting is not to be exactly right. It is to set expectations, build buffers, and prepare for volatility.
So the next time you are underwriting a deal, ask:
What assumptions am I making about NOI?
Are my exit cap rate projections aligned with current market conditions?
Would another buyer agree with this valuation?
If you can answer those questions clearly and defensibly, you are ahead of the game.
Your Turn: How Do You Forecast Cap Rates?
If you have made it this far, we want to hear from you. Do you use market comps, macro forecasts, or a rule of thumb like 10 basis points per year? Have you ever gotten burned—or pleasantly surprised—by an exit valuation?