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The Hidden Risk in Every Underwriting — Exit Cap Rates

The Hidden Risk in Every Underwriting — Exit Cap Rates

The Assumption That Can Break Your Deal

Every multifamily underwriting model eventually comes down to one powerful assumption:

The exit cap rate.

On paper, your deal may look exceptional. Strong IRR. Attractive equity multiple. Solid cash-on-cash.

But change the exit cap rate by 50–100 basis points… and everything shifts.

Let’s break down why this matters.

What Is the Exit Cap Rate?

The exit cap rate is the capitalization rate used to estimate your property’s value at sale.

Value = NOI ÷ Exit Cap Rate

Small changes in the exit cap can dramatically alter valuation.

Example:

If NOI at exit is $2,000,000:

  • At a 5% cap → Value = $40,000,000

  • At a 6% cap → Value = $33,333,333

That’s over $6.6M difference.

A 1% cap shift can reshape investor returns completely.

Why Exit Cap Rates Increase

Cap rates expand when:

  • Interest rates rise

  • Lending becomes tighter

  • Market demand softens

  • Economic uncertainty increases

  • Risk premiums grow

We’ve seen this happen in recent cycles.

Optimistic exit assumptions can quickly become unrealistic.

The 50–100 Basis Point Stress Test

Serious investors should always ask:

“What happens if the exit cap increases by 50–100 bps?”

If your projected IRR collapses under this scenario, the deal may be fragile.

Conservative underwriting includes:

  • Exit cap rate above purchase cap rate

  • Stress-tested IRR scenarios

  • Sensitivity analysis

Hope is not a strategy.

Overly Optimistic Growth Assumptions

Many deals rely on:

  • Aggressive rent growth

  • Compression at exit

  • Perfect execution of value-add plans

But markets don’t always cooperate.

When sponsors assume:

“We’ll buy at 6% and sell at 5%.”

That’s betting on compression.

Disciplined underwriting assumes stability or expansion — not compression.

IRR Can Be Misleading

IRR is sensitive to:

  • Timing

  • Sale price

  • Exit assumptions

Two deals with identical operations can show very different IRRs based purely on exit cap modeling.

Smart investors look beyond headline IRR and examine:

  • Exit sensitivity tables

  • Debt paydown impact

  • Conservative scenarios

Long-Term Investors Think Differently

Experienced operators underwrite defensively.

They ask:

  • What if rates stay elevated?

  • What if buyer demand shrinks?

  • What if liquidity tightens?

Strong deals still work under moderate stress.

Weak deals only work in perfect conditions.

How to Evaluate Exit Risk

Before investing, ask:

  • Is the exit cap rate at least 50 bps higher than entry?

  • Has the sponsor modeled a 100 bps stress case?

  • Does the deal still produce acceptable returns under stress?

  • Are we relying on cap rate compression?

If the deal only works with optimistic assumptions, it’s speculative.

Final Thought: Conservative Assumptions Create Durable Deals

Multifamily investing is not about predicting the perfect market.

It’s about building margin for error.

Exit cap rates are one of the most powerful variables in underwriting. Treat them with caution.

Small assumptions create large consequences.

Before investing, always ask:

“What happens if we’re wrong?”

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