Investors and stakeholders in the net lease real estate world will be familiar with the term capitalization or “cap” rate. Cap rate is a term used by net lease brokers to describe the value of a property, the yield a property provides, and the supposed risk associated with that property.
Cap rates for comparable sales are thrown around casually in conversation as the end-all-be-all for determining a property’s value. However, little thought and discussion is given to the components that make up the cap rate for a net lease property. This causes the cap rate to be subjective and open to varied interpretation, rather than a concrete determinant of the value a net lease property should command.
Simply speaking, the equation to determine a cap rate is “NET INCOME / SALES PRICE = CAPITALIZATION RATE” and equates to the yield or return an investor is willing to accept for a specific property.
The net lease industry is driven by cap rates for comparable properties (e.g. a Starbucks with 10 years on the lease in Arizona sold for a 5.50% cap rate. Therefore, a Starbucks with 10 years on the lease in New Mexico should also sell for a 5.50% cap rate.).
In actuality the cap rate should be broken down into individual components of RISK in order to make smart net lease investment decisions. There must be an appropriate risk adjusted spread over the risk free rate (we utilize the trailing 6-month average yield for the 10-Yr Treasury Note as the risk free rate due to the similar timeline to net leases with national tenants) to consider purchasing a net lease asset.
The items below are possible to quantify in dollar amounts or basis points (1 basis point = 0.01%), and should be added to the risk free rate to determine the true cap rate for a net lease property.
Tenant default risk
The default risk rate addresses the likelihood of your tenant defaulting over the term of their lease. This rate may be determined by looking at the historical average default rates published by Standard & Poor’s and Moody’s.
The chart below shows the significant increase in the likelihood of default for tenants with a rating less than BBB. Tenants with a financial position equivalent to a “B” rating from S&P have a 25% chance of defaulting over a 10-year period. This is a significant increase in risk compared to the less than 1% chance for tenants with “AA” ratings, and should be reflected in the cap rate!
Lease terms and inflation risk
The net lease industry is hedged against the individual investor. Tenants work with developers who do not plan to hold the property as a long term investment, and therefore agree to lease terms which favor the tenant, not the long-term landlord. These lease terms may take the form of restrictive use covenants, the right to sublease without landlord approval, or tenant termination rights among many other lease clauses.
Leases with rent increases which do not match expected inflation rates imply that the landlord will receive rent in the future that has a lower present value than the current rent.
Landlords, their attorneys, and their brokers should pay critical attention to the terms of the lease to identify any clauses which pose a risk to the landlord’s investment. These risks should be calculated in the purchase price.
Real estate and physical building risk (location, market, rents, deferred maintenance, supply of competitive properties)
Many net lease investors fail to consider the importance of physical real estate and surrounding market environment as a risk condition. A long term lease with a credit worthy tenant lulls net lease investors and net lease brokers into a false sense of security.
The reality with net lease real estate is that tenants will not renew their options outright unless the options are weighted in their favor. Net lease investors must carefully research the conditions surrounding a property before they purchase the asset.
Aspects to consider during the due diligence stage include traffic counts in front of the site, access in and out of the site, signalized corner access, leasing activity in the market, deferred maintenance at the property, in-place rents compared to market rents, and the supply of competitive properties for a tenant to relocate.
Liquidity risk in real estate relates to the macroeconomic market and the availability of debt as well as the local real estate market’s attractiveness to investors. Important considerations include the commercial real estate transaction volume in the market and the total amount of commercial loans issued across the United States over the past 3 months. Low sales volume in the surrounding area of the property and low levels of debt being issued may require a drop in price and increase in cap rate to attract investors. Net lease property investors should consider both of these effects when purchasing an asset.
Economic market risk
This is the most challenging component of risk to predict. The economy and global markets are increasingly volatile. Investors should not try to predict this risk component, but make sure all other components of risk are properly weighted so the investment will perform exceedingly well no matter what the macroeconomic situation is around the net lease asset.
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Hopefully this outline helps you along your ownership journey!
We offer multiple ways to benefit from our expertise if you have questions or are in need of help. We offer service plans that correspond to the needs of landlords throughout the ownership life cycle, and for a period of time, our Senior Director of Asset Management, Noah Shaffer, is answering submitted questions.