FAQ: How Much Exit Cap Expansion Should You Model?
A flat exit cap is an assumption, not a forecast — and it was the single most destructive line in 2021 underwriting. How much expansion to model, and why.
Short answer: at minimum 50 basis points over a five-year hold, 75–100 bps in a tertiary market, and always show a scenario where the exit cap equals your entry cap plus 150.
The longer answer is why, and why anything less is not really an assumption at all.
What exit cap expansion does to a deal
Value is NOI divided by cap rate, so the exit cap is a divisor applied to your entire terminal value. On $1,000,000 of stabilised NOI:
| Exit cap | Terminal value | Change |
|---|---|---|
| 5.50% (entry) | $18,182,000 | — |
| 6.00% | $16,667,000 | −8.3% |
| 6.50% | $15,385,000 | −15.4% |
| 7.00% | $14,286,000 | −21.4% |
A 150 basis point move removes a fifth of the gross value. Against a levered equity position that is frequently most or all of the equity — which is precisely what happened to deals underwritten in 2021 at compressed caps and exited into 2024.
Note the asymmetry: the value effect of cap expansion is larger than an equivalent proportional miss on NOI, because it applies to everything at once.
Why "flat" is not a neutral assumption
Underwriting an exit at your entry cap feels conservative because it forecasts no improvement. It is not neutral — it is a forecast that market pricing five years from now will be exactly what it is today, which is a specific and fairly strong claim.
It is also usually the assumption doing the most work in the model. If a deal only clears its return threshold at a flat exit cap, the return is a bet on the capital markets rather than on your business plan.
How much to model
Baseline: 10 bps per year of hold. A five-year hold gets 50 bps. This is the floor, not the answer.
Add for market thinness. In a secondary market, 75 bps over five years; in a tertiary market, 100. Cap rates in thin markets are more volatile and less supported by transaction evidence, and the buyer pool that sets them is smaller.
Add for asset risk. Older stock, single-tenant exposure, a property type with structural questions, or heavy deferred capex all widen the spread a future buyer will demand.
Add for entry-cap compression. If you are buying at a cap rate materially below the market's own ten-year average, you are buying at a point that mean reversion works against. Model the reversion.
Always run entry + 150. Not as the base case — as the survivability test. If entry + 150 wipes out the equity, that is a fact about your capital structure worth knowing before you close rather than after.
The relationship people miss
Exit cap expansion does not arrive alone. The conditions that push cap rates up — higher rates, tighter credit, weaker demand — also push NOI down and refinance proceeds down at the same time.
A sensitivity table showing exit cap in isolation therefore understates the risk. Model the correlated version: exit cap up, NOI down, refinance proceeds down, disposition timeline longer. See DSCR sensitivity design for smaller lending pools for how to structure that.
What a defensible assumption looks like
Three things make an exit cap assumption arguable rather than asserted:
- State the market's own history. What has the cap rate range been in this submarket over ten years? Buying at the bottom of that range and exiting at the midpoint is a reasonable base case; exiting at the bottom is not.
- Separate the components. Part of a cap rate is the risk-free rate and part is a risk premium. If you are underwriting an exit five years out, say which component you expect to move. Translating rate-cut paths into cap rate and valuation outcomes is the scenario version of that question, and it is a more honest way to express a rate view than embedding one in a single exit assumption.
- Show the break-even. At what exit cap does the deal return zero to equity? That single number is more informative to a committee than any table, and it belongs in the memo.
For limited partners reading an offering
The exit cap assumption is the fastest way to assess a sponsor's underwriting discipline.
- Flat or compressing exit cap — the sponsor is projecting favourable capital markets and calling it a business plan.
- Expansion below 10 bps per year — thin.
- Expansion of 50–100 bps with a stated rationale, plus a downside at +150 — someone has thought about it.
Ask for the equity return at entry cap + 150. If the sponsor has not run it, that is the answer.
What to do next
- Run the combined test in cap rate, debt yield and exit cap stress test.
- Check the maturity side with how to underwrite refinance risk in non-core markets.
- Model the hold with the IRR & hold period calculator.
- Decide the timing question in what hold period works best in secondary markets.
Sources
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