💼 How Do We Determine the Exit Cap Rate & Discount Rate in CRE Underwriting?

One of the most fundamental but often misunderstood parts of modeling real estate investments is estimating exit cap rates and discount rates, especially when you're given today's stabilized market cap rate and an expected income growth trajectory.

Let's break it down:

1. Exit Cap Rate = Market Cap + Risk Adjustment

The exit cap rate reflects what the market might pay for the asset's income stream at the time of sale (often 5–10 years out). Even if the asset is stabilized today, future market conditions are uncertain.

🧠 We generally add 25–75 basis points to the current market cap to build in:

Market volatility
Interest rate movement
Asset aging
Capital expenditure exposure

Potential buyer yield expectations

📌 If the current stabilized market cap is 6.00%, it's common to underwrite an exit cap of 6.50%.

2. Discount Rate = Required Return (Adjusted for NOI Growth)

The discount rate (or IRR hurdle) is the investor's required return for accepting the risk of the investment.

Cap Rate = Discount Rate - NOI Growth -> Discount Rate

Real-World Example:

-Imagine you're considering buying a 10-unit apartment building in Florida.
-It currently generates $120,000 per year in net operating income (NOI).
-The market cap rate for similar stabilized buildings is 6.%.

You expect rents to increase by 3.% every year because of rising demand in the area%.

- Market Cap Rate = 6%
- NOI Growth Rate = 3%
⇒ Discount Rate = 9%

Further adjustment consideration, discount rate for:

Asset type (core vs. value-add vs. opportunistic)
Market tier (gateway city vs. secondary/tertiary)
Tenant risk profile
Financing structure
Exit strategy optionality

A suburban medical office in Florida with long-term NNN leases may warrant an 8.5% discount rate. A downtown adaptive-reuse hotel may demand 12%+

📈 Final Thought:
Both assumptions live at the heart of intelligent underwriting.

If you're not modeling these levers with intention, you're not pricing risk you're just hoping for upside.