Syndication Launch Newsletter #00115

The Underwriting Mistake That Can Kill Your IRR

When it comes to syndicating commercial real estate deals, there's one number that makes or breaks your investor pitch: IRR (Internal Rate of Return).

It’s the gold standard for measuring the profitability of your deal over time. Nail it, and you’ll have capital commitments. Miss it—and the entire deal could blow up.

Here’s the kicker: one simple underwriting mistake can silently erode your IRR—sometimes before you even close.

The Culprit: Overestimating the Reversion Cap Rate

The reversion cap rate (also known as the exit cap rate) is the projected capitalization rate at which you expect to sell the property in the future. It’s one of the most sensitive variables in your underwriting model.

Many new syndicators make this mistake:
They assume the cap rate at sale will either stay flat or compress (go down), meaning they'll sell the property for a higher price relative to NOI.

This is dangerous.

In reality, cap rates often expand over time—especially in rising interest rate environments or economic uncertainty. If you project a sale at a 5% cap rate today, but end up selling at a 6.5% cap rate, your sale price could drop millions below your projection. That difference gets passed directly to your investors—and shows up as a lower IRR.

A Conservative Rule of Thumb

Sponsors typically add a buffer to today’s market cap rate when projecting exit cap rates.

Example:

• Market cap rate today: 5.5%

• Exit cap rate in year 5: 6.0%–6.5%

This buffers your underwriting model against future market volatility—and positions you as a conservative operator in your investors’ eyes.

The Real Cost of Misjudgment

Here’s a quick scenario:

• You’re projecting a sale at $20M with a 5% cap.

• The market shifts, and you can only sell at a 6% cap.

• Your sale price drops to $16.67M—a $3.3M shortfall.

That loss doesn’t just eat into profits. It shreds your IRR—especially when compounded over multiple years and fees.

How to Stress-Test Your IRR

To avoid this trap:

• Run sensitivity analyses on your exit cap rate. What happens to IRR if it’s 50–100 bps higher?

• Always include downside scenarios in your investor decks.

• Be transparent. Sophisticated investors appreciate conservative assumptions more than blue-sky projections.

Self-Check Quiz: Are You Protecting Your IRR?

Use these questions to reflect on your current underwriting approach.

1. When you underwrite a deal, do you project that the property will sell for more than you paid—regardless of market trends?
   → How realistic is that assumption in today’s environment?
   

2. Have you ever increased the cap rate in your exit model to reflect potential market softening?
   → If not, what would happen to your IRR if the market softened by even 0.5%?
   

3. Do you include a downside scenario in your investor deck that shows a less favorable reversion cap rate?
   → Would your deal still be attractive if things didn’t go as planned?
   

4. How often do you run a sensitivity analysis to see how small changes in exit assumptions affect returns?
   → Have you ever been surprised by how much the IRR can drop with just minor tweaks?
   

5. Are your underwriting assumptions based on hope… or data?
   → Where do you get your cap rate inputs—from market data, broker opinions, or gut instinct?

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