• In real estate investing, 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 real estate investors interested in gaining exposure to net leased rental properties, one potential way to do so is through partnering with a private equity firm.

Commercial real estate valuations are driven by a number of factors, but two of the most important are the tenant lease types and the prevailing cap rate(s) for 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 drive cap rate trends and valuations for net leased properties.

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.  To learn more about our current investment opportunities, click here.

Net Lease Cap Rate Trends for 2021

Current net lease cap rates tend to vary between 4.00% and 7.00%. Over the course of 2021, cap rates experienced dips into the upper 5.0% range. That said, the average net lease cap rates for the year hover around 6.2%.

Net Leases Explained

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 property owner pays for them with the rental income generated by tenant leases.  In a net lease, the tenant is responsible for some or all of the operating expenses, 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 operating 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 equal to 100%.

Of the four 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 real estate performance metric that describes the relationship 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 potential 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 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 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 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.

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 info@fnrpusa.com for more information.

 

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