Question

Given today’s real estate and interest rate market environments, what is the problem with defining a “Terminal CAP” with a normal distribution? Suggest a different kind of distribution that might be more suitable and explain how this distribution is likely to affect your IRR output compared with a normal distribution. Will it increase the chance that you will earn your required rate of return?

Answer 1

What Is Terminal Capitalization (Terminal Cap.) Rate?

The terminal capitalization rate is the rate used to estimate the resale value of a property at the end of the holding period. The expected net operating income (NOI) per year is divided by the terminal cap rate (expressed as a percentage) to get the terminal value. Terminal capitalization rates are estimated based on comparable transaction data or what is believed to be appropriate for a particular property's location and attributes.

Understanding Terminal Capitalization Rate

The terminal capitalization rate is also known as an exit rate. The going-in rate for a property is projected first-year NOI divided by the purchase price of the property. The terminal capitalization rate is the projected NOI of the last year (or the exit year) divided by the sale price. If this rate is lower than the going-in rate, it usually means that the property investment was profitable.

What’s the relation between the cap rate and the discount rate?

The cap rate allows us to value a property based on a single year’s NOI. So, if a property had an NOI of $80,000 and we thought it should trade at an 8% cap rate, then we could estimate its value at $1,000,000.

The discount rate, on the other hand, is the investor’s required rate of return. The discount rate is used to discount future cash flows back to the present to determine value and account’s for all years in the holding period, not just a single year like the cap rate.

Other specifications about Terminal Cap and IRR

If a property’s cash flows are expected to increase or decrease over the holding period, then the cap rate will be a misleading performance indicator Capitalization rate is used by investors and appraisers to convert net rental income of a property into property value.

Low cap rate implies expectations of higher rent and diminishing returns. Conversely, high cap rates imply the expectation of weakening rents and high required rate of return.

Output of some earlier years Researches

Our estimation results reveal that cap rate is significantly related to both future expected return and expected rental growth Expected return is positively related to cap rate while rental growth is negatively related to cap rate, consistent with the common wisdom that low cap rates imply expectations of higher rent and/or diminishing returns.