When purchasing a commercial real estate asset, one of the challenges that investors commonly face is how much to pay for the property – there are a variety of valuation techniques and the result can vary significantly based on the specifics of the property. One of the ways that a property can be valued is using its capitalization rate – cap rate for short – and one of the factors that can influence cap rates is the type of lease that the tenants have signed.
In this article, we will define what cap rates are and how they are impacted by a type of lease known as a “net lease.” By the end, readers should be able to use this information to estimate the value of a net leased property.
At First National Realty Partners, we utilize the cap rate– and other techniques – to determine the value of net leased properties and as a filter to determine the most attractive investments. To learn more about our current investment opportunities, click here.
What Are Cap Rates?
An investment property’s cap rate 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 / Property Value
Net operating income is calculated as a property’s gross income less its operating expenses and the value is derived from a third party appraisal or purchase price. The result of this calculation provides two key pieces of information about a property:
- It provides real estate investors with an indication of the property’s annual return assuming it is purchased with cash.
- It provides investors with an indication of a property’s level of risk. A higher cap rate indicates more risk, which is why investors need a higher return. A lower cap rate indicates less risk, which is why investors are willing to accept a lower return.
With regard to the second point, cap rates are impacted by many factors that increase or decrease the amount of risk associated with a property. Among these is the type of lease.
What Are Net Leases?
A net lease is a commercial real estate lease type that requires tenants to pay a base monthly rental amount plus some portion of the property’s operating expenses. There are four types of net leases. They include:
- Single Net Lease: In a single net lease, the tenant pays base monthly rent plus their share of one of the property’s major expense categories, usually real estate taxes.
- Double Net Lease: In a double net lease, the tenant pays base monthly rent plus their share of two of the property’s major expense categories, usually property taxes and insurance.
- Triple Net Lease: The tenant pays base monthly rent plus their share of three of the property’s major expense categories, usually real estate taxes, insurance, and maintenance.
- Absolute Net Lease: In an absolute net lease, the tenant pays base monthly rent, plus all of the property’s operating expenses.
Of these four types, the triple net lease is particularly popular with real estate investors.
Why Triple Net Leases Are Popular With Investors
There are four reasons that triple net leased properties (NNN properties) are popular with investors:
- Passive Income: Because the tenant is responsible for taxes, insurance, and maintenance, a triple net leased real estate investment provides investors with a stream of passive cash flow. In other words, investors get the benefits of property ownership, but without the hassle of managing it.
- High Quality Tenants: Triple net leased properties often come with high quality tenants that have strong credit ratings. For investors, this decreases the property’s credit risk and ensures that their rental income is stable and consistent.
- Long Lease Terms: Triple net leased properties often come with long term leases that can stretch up to 25 years. Again, this provides investors with some comfort that they will receive a stable return on investment.
- Demand: When it comes time to sell a triple net leased investment, investors may be happy to find that there is a strong demand for triple net leased properties for all of the reasons above. This usually makes it slightly easier and faster to sell a property for a price that provides a positive return on investment.
To this last point, the price that a triple net leased property sells for – as measured by the cap rate – is heavily influenced by a number of key factors.
What Drives Net Lease Cap Rates?
As described above, net lease cap rates are driven by risk. If a rental property has higher risk, it comes with a lower potential purchase price. If it has lower risk, it comes with a higher purchase price. To this point, there are a number of factors that drive net lease cap rates. They include:
- Property Type: Each commercial property type has a different risk profile. Risker property types like hotels and restaurants tend to have higher cap rates than property types that traditionally have less risk.
- Remaining Lease Term: Leases that expire within a few years of the purchase date raise the risk profile of a property, driving cap rates higher. This is because there is some risk that the tenant(s) won’t renew their lease or they will renew it, but at a lower rental rate.
- Tenant Credit Quality: Well known, financially secure tenants have lower default risk. These are often referred to as “credit tenants” and they include companies like CVS, Walgreens, Starbucks, and Dollar General. Tenants that don’t have the same level of financial strength raise the level of risk, driving cap rates higher.
- Real Estate Market & Location: Better, more visible locations are more desirable and lead to lower cap rates. Locations that are far from major roads or transportation arteries are less desirable and lead to higher cap rates.
- Rental Rates: Properties with higher rental rates tend to be more profitable than those with lower rates. As a result, they will have lower cap rates. Less profitable properties have higher cap rates.
The bottom line is this: properties with more risk have higher cap rates and sell for lower prices. At the other end of the spectrum, properties with lower risk have lower cap rates and tend to sell for higher prices.
What is a Good Cap Rate For a Triple Net Leased Property?
Remember, a property’s cap rate is an indication of the rate of return an investor could expect if they made a cash purchase. So, the answer to the question posed above is somewhat subjective because it is based on each investor’s return objectives, real estate investment strategy, and risk tolerance. For one investor, 6% may be a good cap rate because they prioritize stability and consistency. But, another investor may be willing to take more risk and want to see a cap rate in the 10% range.
With this concept in mind, it is a safe assumption to say that most triple net leased properties trade somewhere in the range of a 4% – 10% cap rate.
Summary & Conclusion
A cap rate is a commercial real estate performance metric that describes the relationship between a property’s net operating income and its value. The result of the calculation provides investors with an indication of their potential return on investment, assuming the property was purchased with cash.
A net lease is a type of commercial real estate lease that requires a tenant to pay a base monthly rental amount plus some portion of the property’s operating expenses.
A type of net lease, the triple net lease, is particularly popular with real estate investors because they provide passive income, long term leases, and usually have high quality tenants.
The investment returns for a triple net property – represented by the cap rate – are impacted by a variety of factors, all related to the inherent risk associated with the asset.
A good cap rate is somewhat subjective because it is highly dependent upon an individual investor’s preferences. However, the majority of triple net leased properties tend to trade in the cap rate range of 4% – 10%.
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.
