When investing in commercial real estate, one of the first things investors look at is the capitalization rate, or cap rate as most commonly referred, and in the triple net (NNN) lease market, the cap rate is a driving force. The cap rate is the ratio between the net operating income produced by a property and the cost of the capital (the purchase price paid to acquire the asset), or by its current market value. It is a simple calculation:
Cap Rate = Annual Net Operating Income (Rent) / Cost (Value of Asset)
Steps to Calculate the Cap Rate:
- Figure out the yearly gross income the property makes. This is usually be the rent that the property generates. However, there may be other sources of income for the property that should also be included.
- Subtract the annual operating expenses from the gross income. This should include maintenance, taxes, insurance, utilities, property management, and any other expenses. Do not include the business expenses in this total. Mortgage payments and other fees are not considered operating costs. Subtract total amount of operating expenses from the gross income amount. This will be the amount of the property’s net income.
- Divide the net income by the property’s purchase price. This is the cap rate.
For example, if a property sold for $1 million and it had a net operating income of $100,000, then the cap rate would be $10,000/$1 million which equals 10 percent.
Cap rates are a useful tool in commercial real estate investments for several reasons. It can be used to determine one property’s potential over another’s. A property with a cap rate of 5 percent compared to another property that is similar in both type and location with a cap rate of 10 percent would quickly alert a potential investor know which property has a higher risk premium.
Investors can also look at cap rate trends to see where the market may be headed. Historical cap rate data may be a good indicator as to what direction valuations are going and whether markets are heating up.
As mentioned above, the net lease market is driven by the cap rate, and is often the sole focus of investors as a measure of value. However, it doesn’t tell the whole story and the cap rate must also be understood in regard to the economy. A simple rule of thumb though, as cap rates decrease, sales prices tend to increase, and conversely, as cap rates rise, prices will drop. Keep in mind, most net lease assets have long term leases, so the net operating income (NOI) is quite stable – thus reflecting the corresponding changes between cap rates and asset prices.
Understandably, average cap rates will vary based upon the sector of the net lease market. And even within sectors, you will see a variance in cap rates based upon the tenancy in the assets, obviously the more investment grade worthy the tenant, the lower the risk.
Net lease cap rates trend relative to the Federal interest rates – as the interest rate hikes, cap rates trend upward with a minimal lag time. You can also watch the US Treasury Rates, cap rates mirror these movements. Generally speaking, there is at least a 4 point spread between the Treasury Rates and the average net lease cap rates, cap rates being the higher number.
Some of the factors which are taken into account include:
- The age of the property
- The tenant’s credit worthiness
- The diversity of the tenants
- How long the lease is for
- The supply and demand for the asset class type of property (i.e. industrial, office, retail, etc.)
- Location of the property
- Interest rates. Keep in mind that any adjustment of rates by the federal government can cause a cap rate to fluctuate by up to 1 percent.
- Regional economic fundamentals, such as employment growth, population growth, and market inventory
These rates do see upward and downward movement, but no major shifts occur overnight. If you look at recent research from Calkain, you can see that from 2012 to 2016, single tenant net lease (STNL) cap rates have only slightly dropped, having been at historic lows for several years.
With the 2017 change in administration and the rising interest rates, cap rates will still remain low, however a slight uptick is expected. The net lease market will begin to shift away from landlords and start to favor the buyers.
When looking to invest in commercial real estate, you will see that the cap rates for net lease assets are lower than those for office and multifamily assets. Office and multifamily tend to have significantly higher risks, and therefore investors expect to have higher returns. You can find out more about the benefits of investing in net lease in Calkain’s Net Lease 101 section.
Cap rates are a good way of comparing properties and providing an estimate of what type of income it good generate. Although cap rates can be very helpful in finding the right investment property, it should not be the only factor used. Keep in mind that although it is useful for easy and quick property comparisons, a potential investor will also want to examine what type of income growth potential the property offers and what are the potential risks of any changes to the property’s value.
Cap rates can be helpful to determine what type of income the property would need to generate in order to make it a worthwhile one. This can be done by taking the property’s price and multiplying it by the cap rate of similar properties. That figure will give the amount of needed income.
As an investor, remember to weigh all the options and not focus solely on the cap rate. High cap rates don’t necessarily make for the best investments – remember, cap rates are also reflective of risk. You might find a great piece of land/building, but have a short term lease with a terrible tenant. Ownership type, deal structure, tenancy, etc., are all factors that need to be considered. Calkain’s experienced team that focuses only on net lease assets can help guide you through this process.Cap Rate