Goal Seek the growth rate, then bridge the gap to the rule of thumb: costs, capex and a wider exit each have to be earned back.
To find the rental growth a property needs, build the unlevered cash flows with growth as the only unknown and solve for the rate at which the IRR equals your target, with Goal Seek or a two-line bisection. On an illustrative 25,000,000 building bought at a 5.50 per cent cap rate, held ten years and sold at 6.00 per cent, an 8.00 per cent IRR needs NOI to grow 4.31 per cent a year, not the 2.50 per cent that "target minus cap rate" suggests. At an underwritten 2.00 per cent the same deal returns 5.73 per cent.
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 →
Turning the question round is the quickest test of an underwriting. A buyer who says "8 per cent at 2 per cent growth" has assumed something else as well, usually a lower exit yield, and solving for growth exposes it.
| Input | Value |
|---|---|
| Price | 25,000,000 |
| Purchaser's costs | 5.0% |
| Total outlay, year 0 | 26,250,000 |
| NOI, year 1 | 1,375,000 |
| Going-in cap rate on price | 5.50% |
| Capital expenditure reserve, share of NOI | 5% |
| Hold, years | 10 |
| Exit yield, on year-11 NOI | 6.00% |
| Selling costs | 2.0% |
| Target unlevered IRR | 8.00% |
CF0 = −price × (1 + costs)
CFt = NOI1 × (1 + g)t−1 × (1 − capex share), t = 1 to 10
Sale in year 10 = NOI1 × (1 + g)10 ÷ exit yield × (1 − selling costs)
Solve for g such that IRR(CF) = 8.00 per cent. In Excel, put g in one cell, build the row from it, compute =IRR(B10:L10), then Data, What-If Analysis, Goal Seek: set the IRR cell to 0.08 by changing the growth cell.
The solver lands on 4.31 per cent. At that rate year-1 NOI of 1,375,000 reaches 2,009,423 in year 10 and 2,095,941 in year 11, an increase of 52.4 per cent over the hold. The sale nets 34,233,703, the final year's cash flow is 36,142,655, and the property returns 50,140,744 in all on 26,250,000, a multiple of 1.91x.
At the 2.00 per cent the underwriting assumed, year-11 NOI is only 1,676,117, the sale nets 27,376,583 and the IRR is 5.73 per cent. The target is not missed by a little.
The shortcut "IRR = cap rate + growth" holds only when nothing leaks: no purchase or sale costs, no capex, and an exit at the entry yield. Each leak has to be made up by growth. Adding them one at a time, in this order:
| Step | Required growth | Adds |
|---|---|---|
| Rule of thumb: 8.00% target less 5.50% cap | 2.50% | |
| Add capex reserve and selling costs | 2.94% | 44 bp |
| Add 5.0% purchaser's costs | 3.59% | 65 bp |
| Exit 50 bp wider, at 6.00% | 4.31% | 71 bp |
| Total gap | 181 bp |
Purchaser's costs matter because they lower the true entry yield: 1,375,000 on an outlay of 26,250,000 is 5.24 per cent, and after the capex reserve the cash yield is 4.98 per cent. The 50 basis points of exit widening matter because they take back part of the value the growth created. The order changes the size of each step a little but not the total.
A required growth rate is a number to argue with, not a forecast. Set it beside what the building's rent roll can deliver: how much of the income is below market, when the leases reach review or expiry, and what the indexation clauses allow. If 4.31 per cent a year needs open-market rental growth well above anything the location has shown, the price is the problem, not the growth assumption. The solve is on NOI: rent growth and NOI growth are the same rate only when non-recoverable costs grow in step with rents. Where costs rise faster, the rent has to grow by more than the figure solved here.
| Target IRR | Exit 5.50% | Exit 6.00% | Exit 6.50% |
|---|---|---|---|
| 6% | 1.58% | 2.27% | 2.91% |
| 7% | 2.59% | 3.29% | 3.93% |
| 8% | 3.59% | 4.31% | 4.96% |
| 9% | 4.60% | 5.32% | 5.98% |
Each point of target IRR costs about one point of growth; each 50 basis points of exit yield costs about 0.65 to 0.71 of a point. The hold matters too, in the opposite direction from intuition: at 8.00 per cent and a 6.00 per cent exit, a seven-year hold needs 5.01 per cent and a five-year hold 5.97 per cent, because the transaction costs and the exit widening are recovered over fewer years.
Read the other way, the IRR at flat growth is 3.76 per cent, at 1 per cent 4.74, at 2 per cent 5.73 and at 3 per cent 6.71: each point of growth is worth about one point of IRR on this deal.
The mistake is to check a target with the cap-plus-growth identity and stop. It is exact only on a frictionless deal, and real deals are not frictionless; the identity and its limits are set out in is a property's unlevered IRR equal to the cap rate plus growth. The second mistake is to solve for growth with the exit yield held at the entry yield, which hides 71 basis points of required growth here inside an assumption that the market will pay the same yield for a building ten years older. The mirror question, how far the exit yield can move with growth held, is answered in how to calculate the break-even exit yield.
Build the cash flows with growth as the unknown and Goal Seek the IRR to the target. Here an 8.00 per cent target needs 4.31 per cent a year, 181 basis points more than the shortcut, because costs, capex and a wider exit all have to be earned back. The same row is laid out in how to calculate IRR in Excel for real estate. Commercial Real Estate Investing attributes one estate's return to rental growth, the business plan, the exit yield and leverage; the free workbooks for this case carry the attribution as live formulas.
Only on a frictionless deal, with no transaction costs, no capex and an exit at the entry yield. Here the shortcut says 2.50 per cent growth for an 8.00 per cent IRR on a 5.50 per cent cap rate; with 5 per cent purchase costs, a capex reserve, selling costs and a 6.00 per cent exit the answer is 4.31 per cent.
Put the growth rate in one cell and drive every year's NOI and the sale price from it. Compute the IRR of the cash-flow row, then use Goal Seek to set the IRR cell to the target by changing the growth cell. On this deal Goal Seek returns 4.31 per cent for an 8.00 per cent target.
Usually more. Purchase costs and a wider exit yield are fixed amounts that a short hold must recover in fewer years. For an 8.00 per cent target at a 6.00 per cent exit, this property needs 4.31 per cent a year over ten years, 5.01 per cent over seven and 5.97 per cent over five.
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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