Commercial real estate property valuations are driven by a number of factors, but two of the most important are the tenant lease type and the prevailing cap rate(s) in a given market.
In this article, we are going to describe the relationship between property cap rates and a specific type of lease known as a “net lease.” In doing so, we will define key terms and identify the factors that are expected to drive cap rate trends and valuations for net leased properties in 2022.
At First National Realty Partners, we have a significant amount of experience with net leased assets and a firm understanding of what drives cap rates for them. We leverage this experience to identify and present the most promising deals to our investors. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
Net Leases Explained
In order to understand net lease trends, it is first necessary to understand what net leases are.
Commercial real estate investment property leases can be grouped into two categories, gross and net. The key difference between the two is who is responsible for payment of the property’s operating expenses.
In a gross lease, the commercial property owner pays for them. In a net lease, the tenant is responsible for some or all of them, depending on which type of net lease they have signed. There are four:
- Single Net Lease: In a single net lease, the tenant pays base rent plus their share of property taxes.
- Double Net Lease: In a double net lease, the tenant pays base rent plus their share of property taxes and insurance.
- Triple Net Lease (NNN): Tenant pays base rent plus their share of property taxes, insurance, and maintenance.
- Absolute Net Lease: In an absolute net lease, the tenant pays base rent plus all of the costs associated with running the property.
In most cases, the tenant’s “share” of the property’s operating expenses is based on the proportionate amount of space that they rent. If they are the sole occupant, their share is 100%.
Of the four net lease types described above, single tenant properties with triple net leases are particularly popular with individual investors who want exposure to commercial real estate assets, but not the hassle of managing them on a day to day basis. The price and asset value for triple net leased properties are driven by the property’s cap rate.
Cap Rates Explained
A property’s capitalization rate – cap rate for short – is a performance metric that describes the ratio between its net operating income (NOI) and value. The cap rate formula is:
Cap Rate = Net Operating Income / Market Value
The result of the calculation is a percentage that provides investors with the property’s annual rate of return if it is purchased with cash. It also provides real estate investors with an indication of risk – high cap rates mean more risk, which is why investors need a higher return. Low cap rates mean less risk, which is why investors are satisfied with a lower return.
Net Lease Cap Rates
As the formula above suggests, there is a direct relationship between a property’s cap rate and its value. To that point, net lease cap rates and their trends are driven by anything that increases or decreases the level of risk associated with the property. Typical factors include:
- Property Type: Some property types are inherently riskier than others. For example, multifamily properties tend to have less risk so they command a lower cap rate / higher purchase price. At the other end of the spectrum, a property like a hotel has higher risk so they command a higher cap rate / lower purchase price.
- Tenant Quality: A high quality tenant like a national company with a strong credit rating comes with less credit risk, which pushes the cap rate lower. Tenants with less financial strength push cap rates higher because they present more credit risk.
- Real Estate Market: Strong markets like major metro areas with high population growth command lower cap rates because they are considered less risky. Secondary, tertiary, and rural markets command higher cap rates because they tend to be less liquid and attract lower quality tenants.
- Lease Length: Properties with longer term leases have less risk (lower cap rates) than properties with short term leases. This is due to the risk that the tenant will vacate the space or that they will renew their lease at a lower rental rate.
- Property Condition: Recently completed or newly renovated properties have less risk (lower cap rates) than older properties. This is because tenants tend to be willing to pay higher rents for newer properties.
In short, anything that raises the risk profile of a property drives cap rates higher, which means that the current market value declines. Conversely, anything that lowers the risk profile drives cap rates lower, which means that the market value of the property rises.
Now that we’ve discussed the relationship between cap rates and property values, let’s talk about where they may be headed in 2022.
Net Lease Cap Rate Trends for 2022
As we enter 2022, the net lease market is working to digest a substantial amount of news, both good and bad.
The good news is that the unemployment rate is falling to historic lows, the government is set to invest a record amount in national infrastructure, and wages are rising across the board for workers as companies compete for talent.
The bad news is that the pandemic is grinding into its third year with a new, highly transmissible variant that has prompted cities like New York to reinstitute restrictions. In addition, interest rates are rising, inflation is at a 40 year high, and housing affordability continues to be a major issue.
It is against this backdrop that we look at commercial real estate (CRE) cap rate trends for 2022. It is helpful to begin by looking at what happened in the fourth quarter of last year.
Cap Rates in 4Q21
According to The Boulder Group’s 4th Quarter 2021 Net Lease Research Report, cap rates in the single tenant net lease sector rose slightly. In the retail sector, they inched up a few basis points to an average cap rate of 5.88% and in the industrial sector they averaged 6.77%.
While these were slight increases, they remain at historically low levels driven by low interest rates and a significant amount of institutional capital chasing the stable yields that net lease properties can deliver. These facts are reflected in 2021’s record transaction volume of $90+ billion.
Will Cap Rates Continue to Increase in 2022?
The short answer to this question is, time will tell. As the previous paragraph described, they rose slightly in 4Q21, but at the outset of 2022, there is some uncertainty about what will happen.
On one hand, interest rates are rising. In particular, the so-called risk free rate on the 10-year US Treasury has risen from 1.08% to ~1.70% in the first few weeks of 2022, the fastest increase in nearly 20 years. Cap rates tend to move in conjunction with the 10-year treasury suggesting that additional increases are on the horizon, especially for riskier assets.
But, supply constraints for net leased properties and high investor demand provide conflicting evidence that they may be more stable than the treasury move would suggest.
What Do These Trends Mean For Investors?
With these factors in mind, current market indicators seem to indicate that cap rates will rise, albeit slightly, throughout the year. However, riskier triple net assets – those with short term leases or less desirable tenants – are more likely to feel the brunt of this move. Safer assets with high quality tenants – like Walgreens, Dollar General, Amazon, Whole Foods, or McDonald’s – on long term leases are the gold standard for safety in a turbulent market so they may be less exposed to cap rate movement.
If cap rates continue to rise through 2022, there are a number of important implications that investors should consider:
- Values May Compress: Traditionally, rising cap rates are a headwind for property values. The properties most likely to be impacted are those at the higher end of the risk spectrum. For example, net leased properties with short lease terms remaining or those with non-credit tenants may see larger swings in value than those with long term leases and credit tenants.
- Lease Terms are Critical: The good news is that net lease terms often call for periodic rent increases, which can go a long way in helping to offset rising cap rates. Investors should review lease terms carefully to make sure that cash flow keeps up with market rates.
- Fundamentals Matter: Net leased properties should be conservatively underwritten with manageable debt loads that have fixed interest rates, strong locations, and high quality tenants.
- Cap Rates Aren’t Everything: Even if cap rates continue to rise, there are other factors that go into the valuation of a property. For example, the location, tenant, market, finishes, and condition are additional factors that must be considered in the valuation of a property.
While cap rate movements will have an impact on net leased properties in 2022, it is important to note that the largest real estate profits are made over the long term. When viewed through this lens, the year to year cap rate is much less important than investing in a net leased property with strong fundamentals. For those, the long term trend is that property values rise slowly.
Net Lease Cap Rates & Private Equity
Given their popularity with investors, there are certain private equity firms whose investment strategy focuses on buying, managing, and selling properties with net leases. For individual investors who are interested in this asset class, partnering with a private equity firm is a good way to gain fractional ownership of institutional quality, net leased assets.
Final Thoughts on Net Lease Cap Rates
A property’s capitalization rate is a performance metric that provides real estate investors with information about its potential return on investment and risk profile.
A net lease is a type of commercial real estate lease that requires the tenant to pay a base rental amount plus their share of the property’s operating costs. The exact share depends on the specific type of net lease, of which there are four.
There is a direct relationship between a net leased property’s value and its cap rate. A low cap rate means higher value and a high cap rate means lower value.
Factors that can cause a net leased property’s cap rate to change include things like: market, location, tenant quality, and lease length.
For investors interested in gaining exposure to net leased rental properties, one potential way to do so is through partnering with a private equity firm.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.