Entry vs. Exit Cap Rate: What Investors Need to Know

When evaluating commercial real estate investments, understanding cap rates is essential—but knowing the difference between entry cap rates and exit cap rates can be just as important. These two terms influence how an asset is underwritten, valued, and ultimately, how profitable the investment will be over time.

We’ll break down what entry and exit cap rates mean, how they’re used, and why getting them right matters to your investment strategy.

What Is an Entry Cap Rate?

The entry cap rate—also known as the going-in cap rate—represents the yield on a property at the time of acquisition. It is calculated using the property’s current or stabilized Net Operating Income (NOI) divided by the purchase price:

Entry Cap Rate = NOI / Purchase Price

For example, if a property is generating $500,000 in NOI and the purchase price is $10 million, the entry cap rate would be:

$500,000 / $10,000,000 = 5%

This cap rate helps investors assess whether the purchase price offers a fair return based on current income levels.

What Is an Exit Cap Rate?

The exit cap rate—also known as the terminal cap rate—is a projected capitalization rate used to estimate the resale value of a commercial real estate asset at the end of the holding period. It’s a crucial input in pro forma models and discounted cash flow (DCF) analyses.

Unlike the entry cap rate, which reflects the asset’s value at the time of purchase, the exit cap rate reflects assumptions about future market conditions and the property’s performance at the time of sale.

Exit Cap Rate = Net Operating Income (NOI) at Exit / Projected Sale Price

This formula gives you the cap rate you would use to estimate a future sale price, based on what you expect the property’s net income to be at the time of exit.

Understanding and using the correct exit cap rate is essential for accurately forecasting investment returns. A small change in your exit cap rate assumption can significantly affect your projected returns, including IRR (Internal Rate of Return) and equity multiples.

Typically, investors assume a higher exit cap rate than entry to reflect increased uncertainty, aging of the asset, or anticipated market softening. This conservative approach is known as cap rate expansion. However, in strong markets with improving fundamentals, some investors may use a flat or even lower exit cap rate (cap rate compression), though this carries more risk.

Why the Difference Matters

Entry and exit cap rates are fundamental to underwriting a deal. A mismatch between these assumptions can result in mispricing and skewed projections.

In general:

• Entry cap rates reflect market conditions today.
• Exit cap rates are a best guess of future market conditions.

Many investors apply a higher exit cap rate than the entry rate to account for risk—this is known as “cap rate expansion.” For example, if you enter a deal at a 5% cap rate, you might underwrite your exit at 5.5% or 6% to reflect uncertainty in market conditions five to ten years out.

Example of Cap Rate Expansion:

Let’s say you buy a multifamily property at a 4.75% cap rate, expecting NOI growth over five years. If you forecast a 5.5% exit cap, your assumed resale value will be lower than if you projected a 4.75% exit cap—introducing conservatism into your model.

This helps protect your projections from market fluctuations. On the other hand, if market conditions improve dramatically, the actual exit cap may be lower, resulting in a higher-than-expected sales price—and a bonus return for you.

What Influences Entry and Exit Cap Rates?

A range of factors can influence both entry and exit cap rate assumptions, including:

• Interest rates
• Market supply and demand
• Asset class and location
• Tenant creditworthiness
• Lease terms
• Overall macroeconomic conditions

In general, the riskier the asset or market, the higher the cap rate investors will demand.

How to Use Entry and Exit Cap Rates in Your Analysis

Entry and exit cap rates help you:

• Assess whether the purchase price is fair
• Forecast your exit strategy and valuation
• Model potential returns and IRR
• Evaluate risk sensitivity in your assumptions

Be conservative when projecting exit cap rates. Increasing them slightly can help you stay realistic in your underwriting. Use sensitivity analysis to understand how changes in exit cap assumptions impact your projected returns.

Final Thoughts

Entry and exit cap rates are not just abstract numbers—they shape the entire investment outlook. Using them thoughtfully can make the difference between hitting your targets and missing the mark. Remember, a deal that looks good on paper with aggressive assumptions may fall apart if the exit cap rate proves too optimistic.

Want expert guidance on cap rates and investment underwriting? Reach out to the IPG team to get tailored advice for your next acquisition.