Exit cap expansion is a one-off loss of value, so its cost in IRR depends on how many years you have to spread it over, and on the leverage that concentrates it.
A higher exit cap rate is a one-off cut in sale value, so its cost in IRR depends on how long you hold. On an illustrative $50m property bought at a 6.00 per cent cap with 2.5 per cent NOI growth, exiting at 6.50 per cent after five years cuts exit value by 7.7 per cent and the IRR by 144 basis points unlevered and 296 basis points at 55 per cent LTV. Held three years, the same 50 basis points costs 548 basis points of levered IRR.
Worked in full in Real Estate Fund Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most investment committee papers show an exit cap sensitivity, and most readers glance at it as if 50 basis points of expansion were a fixed haircut. It is not. The value loss is fixed; the IRR loss is that value loss divided, roughly, by the years you have to earn it back, then multiplied by leverage. Both effects can be computed in a few rows.
| Input | Value |
|---|---|
| Purchase price | $50,000,000 |
| Year-1 NOI | $3,000,000 |
| Entry cap rate | 6.00% |
| NOI growth a year | 2.5% |
| Selling costs at exit | 1.0% |
| Hold period (base) | 5 years |
| Loan, interest only, 55% LTV | $27,500,000 |
| Interest rate | 5.5% |
| Equity | $22,500,000 |
The exit cap is applied to forward NOI, the year after the sale, as at entry. Annual interest on the loan is $1,512,500 and the loan is repaid in full from the sale proceeds.
Net exit value = NOI in year (hold + 1) ÷ exit cap × (1 − selling costs)
Unlevered IRR = IRR of (−price, NOI years 1 to 5, + net exit in year 5)
Levered IRR = IRR of (−equity, NOI − interest, + net exit − loan in year 5)
In Excel, with NOI in row 5 and the exit cap in a named cell: =G5*(1+Growth)/Exit_Cap*(1-Sell_Cost) for the exit, then =IRR(B10:G10) on the cash-flow row. Point the exit cap at a data table, or better, copy the row once per scenario so the cash flows stay visible.
| Exit cap | Net exit value | Value change | Unlevered IRR | Change | Levered IRR | Change |
|---|---|---|---|---|---|---|
| 6.00% | 56,004,707 | 0.0% | 8.32% | 0 bp | 11.47% | 0 bp |
| 6.25% | 53,764,518 | −4.0% | 7.58% | −74 bp | 9.97% | −149 bp |
| 6.50% | 51,696,652 | −7.7% | 6.88% | −144 bp | 8.51% | −296 bp |
| 7.00% | 48,004,034 | −14.3% | 5.58% | −274 bp | 5.67% | −579 bp |
Two patterns are visible. Leverage roughly doubles the IRR cost, because at 55 per cent LTV every dollar of lost value comes out of an equity cheque that is less than half the price. And at a 7.00 per cent exit the levered IRR of 5.67 per cent is barely above the unlevered 5.58: the deal has reached the point where the debt, at 5.5 per cent, no longer adds anything. Push the exit further and leverage starts to subtract.
| Hold | Unlevered 6.00% | Unlevered 6.50% | Cost | Levered 6.00% | Levered 6.50% | Cost |
|---|---|---|---|---|---|---|
| 3 years | 8.18% | 5.64% | 253 bp | 11.31% | 5.82% | 548 bp |
| 5 years | 8.32% | 6.88% | 144 bp | 11.47% | 8.51% | 296 bp |
| 7 years | 8.38% | 7.41% | 97 bp | 11.46% | 9.57% | 189 bp |
| 10 years | 8.42% | 7.80% | 62 bp | 11.38% | 10.26% | 112 bp |
The base IRR barely moves with the hold, but the cost of expansion falls by three quarters between a three-year and a ten-year exit. This is why exit cap risk belongs mainly to value-add and opportunistic plans with short holds, and why a core buyer can shrug at the same sensitivity. The two-dimensional view adds growth:
| NOI growth | Exit 6.00% | Exit 6.50% | Exit 7.00% |
|---|---|---|---|
| 1.5% | 7.32% | 5.90% | 4.61% |
| 2.5% | 8.32% | 6.88% | 5.58% |
| 3.5% | 9.31% | 7.86% | 6.54% |
The offset is expensive. To keep the unlevered IRR at 8.32 per cent with a 6.50 per cent exit, NOI must grow at 3.96 per cent a year for five years instead of 2.5 per cent. A model that expands the exit cap and quietly raises rental growth to compensate has not been made more conservative.
The common mistake is to treat the value cut as an annual drag. A 7.69 per cent loss spread over five years looks like 154 basis points a year, close to the true 144 unlevered, so the shortcut seems to work. It fails as soon as the hold changes or debt is added: on a three-year levered hold the real cost is 548 basis points, more than twice the 256 basis points a year the shortcut gives for three years. Run the IRR; do not estimate it.
The second mistake is to apply the exit cap to trailing NOI, which is a separate error of one year's growth and is covered in whether the exit cap applies to forward or trailing NOI. To turn the ladder round and find the exit cap at which a target IRR is just met, use the break-even exit yield.
On this deal 50 basis points of exit cap expansion costs 144 basis points of unlevered IRR over five years, 296 levered, and 548 levered over three. State the hold and the leverage next to every exit cap sensitivity, or the number means little. The free workbook for this case carries the exit grid with every cash flow on the page.
Roughly half the cost of 50 basis points, slightly more than half because value is a reciprocal of the cap. On an illustrative five-year hold bought at a 6.00 per cent cap with 2.5 per cent growth, a 6.25 per cent exit takes the unlevered IRR from 8.32 to 7.58 per cent, 74 basis points, and the IRR at 55 per cent LTV from 11.47 to 9.97 per cent, 149 basis points.
Because the value lost at exit is the same whatever the hold, and the IRR spreads it over fewer years. On the illustrative deal a 50 basis point expansion removes 7.7 per cent of exit value; held three years that costs 253 basis points of unlevered IRR, held ten years only 62. A value-add business plan with a three-year exit carries the most exit cap risk per point of return.
On a five-year hold, a lot. Holding the illustrative unlevered IRR at 8.32 per cent with a 6.50 per cent exit cap needs NOI growth of 3.96 per cent a year instead of 2.5 per cent. That is why underwriting cap expansion and then raising rental growth to compensate is a red flag: the two assumptions cancel on paper and not in the market.
Chapter 8 of Real Estate Fund Management asks for a two-dimensional exit grid; the free companion workbook builds it with the cash flows shown rather than hidden behind a data table. 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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