What is the terminal capitalization rate in Commercial real estate investment?

June 25, 2020

Commercial real estate investment has lots of terms and figures, and today, we will be discussing terminal capitalization.

So, what is the terminal capitalization rate?

Also known as the exit rate, the terminal capitalization rate is the rate that is used to estimate the value of a property at the end of the holding period. The terminal value is determined by dividing the Net Operating Income (NOI) per year by the terminal capitalization rate (which is expressed as a percentage). These terminal cap rates are established on the basis of comparable transaction data or what is believed to appropriate for a specific property’s location and attributes.

Understanding terminal capitalization rate:

The going-in capitalization rate is calculated by dividing the first-year Net Operating Income by the initial investment or purchase price. Whereas, the terminal capitalization rate is the projected NOI of the exit year divided by the sale price. If this rate is lower than the going-in capitalization rate, it usually means that the commercial real estate investment was profitable.

The real estate investment experts will agree that it is essential to match the terminal cap rate to the current rate of the market. It is because it may be a safer test for the development to nudge the terminal cap rate up a bit. A dynamic spreadsheet can come in handy to test the development project to establish the highest possible terminal cap rate that would still provide a sufficient upside to investors.

Real estate investors who are really into the market will look for properties whose market capitalization rates are expected to fall. This is because a lower terminal capitalization rate compared to the in-going rate will result in capital gains, assuming that the NOI will not decrease over the holding period. Some of the information that must be taken into account includes supply-and-demand metrics for each classification of space, as well as for the services & expenses assumed to be related to each area of operation.

As the future is always uncertain, two things will undoubtedly change over a period of time – the age of the buildings and the markets. Therefore, it is crucial to compile and analyze as much data as possible to accurately depict the terminal capitalization rate for a property.

Here’s an example of a terminal capitalization rate:

An investor makes a commercial real estate investment for $100 million. First-year NOI is estimated at $5.0 million. The going-in capitalization rate is, therefore, 5%. Seven years later, the investor believes that the terminal cap rate is approximately 4.0%. Last-year NOI, which has taken into account rent escalation along the way, is projected at $5.5 million. The resale value is estimated at $137.5 million ($5.5 million in NOI divided by the 4.0% terminal capitalization).

Key takeaways:

- The terminal capitalization rate is used to estimate the resale value of the property at the end of the holding period

- The going-in cap rate is the projected first-year NOI of the property divided by the property’s purchase price

- A lower terminal capitalization rate means your commercial real estate investment was profitable.

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