Underwriting the Exit: Why the Back of the Napkin Math Matters More Than You Think

Most real estate acquisitions are underwritten forward from today: what is the NOI now, what can we grow it to, and at what cap rate can we exit? The problem with forward underwriting is that it starts with assumptions about the future and builds a return projection on top of them. Assumptions that are wrong in small ways compound into outcomes that are wrong in large ways.

Underwriting the exit starts from a different place. Instead of building toward the best case exit, it stress tests the return against the realistic range of exit scenarios and confirms that the investment makes sense under all of them, not just the best one.

The Three Exit Scenarios

Every acquisition should be modeled against three exit scenarios. The base case uses current cap rates at exit with market rent growth and expense assumptions that match the submarket's historical range. The conservative case assumes cap rates expand 25 to 50 basis points and rent growth comes in at 60% of the base case projection. The stress case assumes cap rates expand 75 to 100 basis points and rent growth is flat.

If the deal generates an acceptable return in the base case and at least capital return in the stress case, the investment thesis is defensible. If the deal only works in the base case or better, the underwriting is too optimistic for the risk you are taking.

Cap Rate Sensitivity Is the Most Important Variable

The relationship between cap rate at exit and asset value is the variable that most investors underestimate. A 40-unit building with stabilized NOI of $350,000 is worth $5.8M at a 6% exit cap and $4.7M at a 7.5% exit cap. That is a $1.1M difference in asset value from a single 150 basis point move in the exit cap rate.

If your deal generates a 15% IRR in the base case and assumes a 6% exit cap, what does the IRR look like at a 7% exit cap? If the answer is 9%, the deal has significant cap rate risk that should be reflected in how you think about the risk-adjusted return.

The Underwriting Tells You What to Pay

The purpose of stress-testing the exit is not to find a reason not to do a deal. It is to determine what you can afford to pay at acquisition and still generate an acceptable return across the range of realistic outcomes. If the stress case at 7.5% exit cap and flat rents only works at a purchase price 8% below the asking price, then 8% below asking is the number.

The discipline is walking away when the seller's price does not accommodate the underwriting. That discipline is harder than any analysis.