Why the expansion in an exit assumption must be measured from the stabilised entry yield, not the headline one, and what 25 basis points does to the IRR.
Usually yes, but only once both yields are measured on the same income. An exit cap rate is stabilised NOI over value, so compare it with the going-in yield on stabilised NOI, not with the headline yield on today's passing income. On an illustrative 20,000,000 office with 1,000,000 of passing NOI and 1,250,000 when let at market, a 6.50 per cent exit looks 150 basis points above the 5.00 per cent headline entry, but is only 25 basis points above the 6.25 per cent like-for-like yield.
Worked in full in Commercial Real Estate Investing by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Investment committees ask one question about the exit assumption more than any other: how much expansion is in it? The answer depends entirely on which entry yield you subtract. On a building with vacancy or rents below market, the headline yield is depressed and the expansion looks generous. On an over-rented building it is the reverse. The arithmetic below puts both yields on one basis.
| Input | Value |
|---|---|
| Purchase price | 20,000,000 |
| Acquisition costs | 2.0% |
| Passing NOI, year 1 (two suites vacant, rents below market) | 1,000,000 |
| Base NOI, year 2, as the suites let | 1,150,000 |
| Stabilised NOI at market rent, today's money (year 3 on) | 1,250,000 |
| NOI growth | 2.5% |
| Leasing capex, years 1 and 2 | 300,000 |
| Exit cap rate, on year-6 NOI | 6.50% |
| Sale costs | 1.5% |
Headline going-in cap rate = passing NOI ÷ price = 1,000,000 ÷ 20,000,000 = 5.00%
Like-for-like going-in cap rate = stabilised NOI ÷ price = 1,250,000 ÷ 20,000,000 = 6.25%
Expansion = exit cap rate − like-for-like going-in = 6.50% − 6.25% = 25 bp
In Excel: =Exit_Cap-Stabilised_NOI/Price, never =Exit_Cap-NOI_Y1/Price.
The 250,000 between passing and stabilised NOI is the business plan: letting two empty suites and moving the rest to market, a 25.0 per cent uplift. The headline yield prices the building before that plan; the exit yield prices it after. Subtracting one from the other mixes two different buildings. On total cost including acquisition costs the headline is lower still, 4.90 per cent, which widens the illusion to 160 basis points. Strictly, the 600,000 of leasing capex is part of the cost of the stabilised building too: on 20,600,000 the like-for-like yield is 6.07 per cent and the expansion 43 basis points, still a long way from 150.
The test: an exit yield and the entry yield it is compared with must share a numerator (stabilised, forward NOI) and a denominator (value before buyer's costs, or after, but the same on both sides).
| Year | NOI | Cash flow |
|---|---|---|
| 0 | −20,400,000 | |
| 1 | 1,000,000 | 700,000 |
| 2 | 1,178,750 | 878,750 |
| 3 | 1,313,281 | 1,313,281 |
| 4 | 1,346,113 | 1,346,113 |
| 5 | 1,379,766 | 22,811,249 |
| Unlevered IRR | 6.29% |
The sale is priced on year-6 NOI of 1,414,260, the first year the buyer owns: 1,414,260 ÷ 6.50% = 21,757,850 gross, 21,431,482 after 1.5 per cent of sale costs. In Excel, =IRR(B2:B7) on the cash flow column returns 6.29 per cent.
| Exit cap rate | vs headline, bp | vs like-for-like, bp | Gross exit value | IRR |
|---|---|---|---|---|
| 6.00% | +100 | −25 | 23,571,004 | 7.74% |
| 6.25% | +125 | 0 | 22,628,164 | 7.00% |
| 6.50% | +150 | +25 | 21,757,850 | 6.29% |
| 6.75% | +175 | +50 | 20,952,004 | 5.62% |
| 7.00% | +200 | +75 | 20,203,718 | 4.98% |
| 7.50% | +250 | +125 | 18,856,804 | 3.78% |
Read the first row. A 6.00 per cent exit is "100 basis points of expansion" on the headline, which sounds prudent, and it is in fact 25 basis points of compression on the stabilised building. It produces a 7.74 per cent IRR that depends on the market paying more for the asset in five years, older, than it pays for the same income today.
Each 25 basis points on the exit moves value by about 3.70 per cent, 805,846 at this point of the table, and the IRR by roughly 0.7 points. A common underwriting convention adds about 10 basis points a year of hold to the like-for-like entry yield, for ageing and for the uncertainty of a sale five years out. Here that is 6.75 per cent, and an IRR of 5.62 instead of 6.29 per cent, 0.67 points less. Whether the convention is right for a given building is a judgement; what is not a judgement is the base it is added to.
The same error runs the other way when passing rent is above market. Buy at 20,000,000 on 1,400,000 of passing NOI and the headline yield is 7.00 per cent. If the rent will fall to 1,200,000 at the next lease event, the like-for-like yield is 6.00 per cent. An exit at 7.00 per cent looks flat against the headline and is in fact 100 basis points of expansion. Committees that reject a lower exit than entry on reflex are penalising the wrong deals.
The common mistake is to set the exit yield as "going-in plus x" using the yield quoted in the offer memorandum. That figure is almost always a headline yield on passing income, sometimes on gross price, sometimes net of costs. On a value-add building it makes an aggressive exit look conservative; on an over-rented one it does the opposite. Compute the stabilised entry yield yourself, on the same NOI definition and the same price basis as the exit, and state the expansion against that number. The forward-year rule for the exit itself is covered in whether the exit cap rate applies to forward or trailing NOI.
An exit cap rate above the headline going-in yield proves nothing. Rebase the entry yield to stabilised NOI, here 6.25 per cent rather than 5.00, and the 150 basis points of apparent prudence shrink to 25. The six entry yields a single deal can carry, and the one that compares with the exit, are computed side by side in the free workbook for this case; how much IRR each step on the exit costs is worked further in how much IRR a 50 bp higher exit cap rate costs.
A common underwriting convention adds about 10 basis points for each year of hold to the stabilised going-in yield, for ageing and uncertainty. On a five-year hold and a 6.25 per cent like-for-like entry yield that gives 6.75 per cent. Each 25 basis points on the exit moved the illustrative IRR by roughly 0.7 points.
On the headline yield, yes, and that can be correct for an over-rented building. Bought at 7.00 per cent on 1,400,000 of passing NOI that will fall to 1,200,000 at market, the like-for-like entry yield is 6.00 per cent. A 7.00 per cent exit is then 100 basis points of expansion, not none, and even a 6.50 per cent exit, below the headline, still carries 50 basis points.
The forward NOI, the first year the buyer owns, stabilised. Here the year-6 NOI of 1,414,260 at 6.50 per cent gives a gross exit value of 21,757,850. Capitalising a year that still carries a void or a rent-free period understates the price a buyer would pay.
This article is one calculation from Commercial Real Estate Investing. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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