Value-Add Exit Timing and the IRR Trap
A private investor is underwriting a 120-unit apartment complex priced at $16,500,000 - a 6.36% year-1 cap on NOI of $1,050,000. The business plan: 65% LTV interest-only debt at 6.25%, a $1,200,000 interior renovation in year one funded from equity, and NOI of $1,180,000, $1,290,000, $1,380,000 and $1,450,000 in years two through five. Closing costs are 1.5% of price; annual capital reserves of $150,000 are deducted from cash flow. Exit is in year five at a 5.75% cap on year-six NOI of $1,495,000, with 2% selling costs. The loan is interest-only throughout. The GP proposes exiting in year three instead, at a 6.00% cap on year-four NOI. The LP's hurdle rate is 15%.
1. Compute the equity requirement, annual cash flows, levered IRR and equity multiple for the five-year hold.
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Equity requirement
- Loan = 65% × $16,500,000 = $10,725,000.
- Closing costs = 1.5% × $16,500,000 = $247,500.
- Equity = $16,500,000 + $247,500 + $1,200,000 renovation − $10,725,000 = $7,222,500.
Annual debt service (interest only) = $10,725,000 × 6.25% = $670,300.
Cash flow (NOI − debt service − reserves)
| Year | NOI | Cash flow |
|---|---|---|
| 1 | $1,050,000 | $229,700 |
| 2 | $1,180,000 | $359,700 |
| 3 | $1,290,000 | $469,700 |
| 4 | $1,380,000 | $559,700 |
| 5 | $1,450,000 | $629,700 |
Exit
- Gross value = $1,495,000 ÷ 0.0575 = $26,000,000; less 2% costs = $25,480,000; less loan payoff $10,725,000 = $14,755,000 of net proceeds.
- Year-5 total distribution = $629,700 + $14,755,000 = $15,384,700.
Returns
- Levered IRR ≈ 19.8% (PV of the cash flows plus exit equals $7,222,500 at about 19.8%).
- Total distributions = $17,003,500; equity multiple = 2.35x; profit = $9,781,000.
The deal clears the 15% hurdle, but roughly 80% of the return comes from the exit, not operations - this is a cap-rate and growth bet, not a cash-flow investment.
2. Evaluate the GP's proposed three-year exit. Reconcile the IRR ranking with the equity multiple and recommend.
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Three-year exit
- Gross value = $1,380,000 ÷ 0.0600 = $23,000,000; less 2% costs = $22,540,000; less $10,725,000 payoff = $11,815,000.
- Year-3 total distribution = $469,700 + $11,815,000 = $12,284,700.
- IRR ≈ 21.8%; total distributions = $12,874,100; equity multiple = 1.78x; profit = $5,651,600.
The reconciliation
- IRR ranks the three-year exit higher (21.8% vs 19.8%) even though it produces $4.1 million less profit and a multiple of 1.78x instead of 2.35x. IRR mechanically rewards returning money sooner, and the 6.00% exit cap in year three is applied to a smaller NOI while still capturing most of the post-renovation value.
- On money actually earned, the five-year hold is clearly superior: 2.35x in five years is about 18.6% annualized on a simple compounding basis versus 1.78x in three years at about 21.2%. The early exit wins the IRR contest but loses the wealth contest.
Recommendation: prefer the five-year hold, subject to two conditions - the renovation must actually deliver the year-two and year-three NOI, and the LP should require that any sale before year four triggers a minimum 2.0x multiple test rather than relying on the IRR hurdle. The GP's incentive matters here: with a straight 30% promote, the GP earns about $2.93 million on the five-year hold versus $1.70 million on the three-year exit, so a GP pushing for the early sale is either signaling doubt about years four and five or trying to lock a promote before performance is proven. An IRR hurdle alone will not stop a GP from selling early; a multiple test or a clawback will.
3. How sensitive is the five-year hold to the exit cap? At what exit cap does the deal stop clearing 15%?
Read the worked answer
If the exit cap is 6.25% instead of 5.75%
- Gross value = $1,495,000 ÷ 0.0625 = $23,920,000; less 2% costs = $23,441,600; less payoff = $12,716,600.
- Year-5 total distribution = $629,700 + $12,716,600 = $13,346,300.
- IRR falls to about 16.8%; multiple = 2.07x.
A 50 bp cap-rate miss costs roughly three points of IRR and $2.5 million of profit.
The 15% break-even cap
- PV of years 1–4 cash flows at 15% = $199,700 + $272,000 + $308,800 + $320,000 = $1,100,500.
- Required PV of the year-5 distribution = $7,222,500 − $1,100,500 = $6,122,000, which at a 2.0114 factor means the exit distribution must be $12,313,000.
- Net sale proceeds = $12,313,000 − $629,700 = $11,683,300; required gross sale value = ($11,683,300 + $10,725,000) ÷ 0.98 = $22,866,000.
- Break-even exit cap = $1,495,000 ÷ $22,866,000 = 6.54%.
What this means
- The underwriting already assumes 61 bp of cap compression from the 6.36% going-in cap to a 5.75% exit. The deal still clears 15% with 18 bp of expansion to 6.54%, so the margin is real but narrow - the return depends on NOI growth, and it survives only a modest rise in cap rates.
- The prudent move is to underwrite the exit at the going-in cap (6.36%), which yields roughly 16.3% and a 2.05x multiple, and to treat anything better as upside. Presenting the LP with only the 5.75% case hides the single assumption that drives the outcome.