The Capitalization Rate (Cap Rate) is the most common term used in the Triple Net world to indicate the rate that an investment is expected to return. It represents the yield of a property over a one year period of time assuming the property is purchased all cash. Generally speaking, the higher the cap rate the riskier the deal.
Characteristics Of A Low Cap Rate Deal (4.00%-6.00% Cap Rate)
New Construction, 10+ Year Lease, Great Real Estate, Strong Credit Backing The Lease, Zero Landlord Responsibilities, Under Market Rents, Hard Corner, Sits At A 4 Way Intersection, Outparcel To A Major Shopping Center, Strong Rent Increases Built Into The Primary Term
An Example of what a 4.00% Cap Rate deal looks like is a new construction Chick Fil A or McDonald’s.These two companies are known for having excellent real estate departments and the dirt they are building on is likely some of the best in that specific market. The chances of McDonald’s going bankrupt and bailing on their lease is extremely limited. Sometimes these deals only make sense for all cash buyers because the potential interest rate on a loan would be higher than the rate of return.
Characteristics Of A Mid Cap Rate Deal (6.00%-7.50% Cap Rate)
New Construction, Tertiary Market, Strong Real Estate (but not the best in town), Franchisee Guaranteeing The Lease, Lesser Known Tenant, Weak or No Rental Increases In Primary Term
Deals in this cap rate range can check a lot of the boxes that fall into lower cap rate ranges, and in our opinion most of the best investments can be found in this range. Maybe instead of a corporate guarantee there is a franchisee guaranteeing the lease. An example of a deal in this range could be a new construction Burger King with a weak franchisee. While the appeal of the Burger King brand may lure in a buyer, if the franchisee only operates 3 units and goes belly up, the fact it is operating as a Burger King is irrelevant.
Characteristics Of A High Cap Rate Deal (7.50%+)
Short Term Lease, Failing Concept, Poor Real Estate
If a deal looks too good to be true it usually is. You need to be on the look out for red flags when you are purchasing a deal in this cap rate range. While it may be nice to chase the yield of a higher cap rate deal, these should be reserved for savvy buyers. To often we have seen first time buyers get lured into the trap of a high cap rate deal, only for the tenant to bail on their lease. An example of this type of deal would be a Fred’s Super Dollar Store. These deals can be had for 10%+ Cap Rates, but the company’s stock has dropped over 80% within the last 2 years.
What Determines A Cap Rate
*Age, location and status of the property
*Term and structure of tenant lease(s)
*Overall market rate of the property and the factors affecting its valuation
*Macroeconomic fundamentals of the region as well as factors impacting tenants’ businesses
*Strength Of The Guarantee
Using Cap Rates To Determine A Sales Price
Market cap rates are one of the major keys when determining the sale price of an asset. For example, new construction Dollar Generals currently being built in towns of 3,000 people are typically selling for a 7% Cap Rate. You may ask, how do you know these deals are typically trading at 7% Cap Rates? There are several websites such as LoopNet, CREXI, and hundreds of brokerage website that have there deals listed. By keeping up with email blasts and other marketing websites where properties are listed for sale you should be able to get a very good idea of the average cap rates for a specific product type. Let’s say someone approached you about buying a new construction Dollar General in a small town in Ohio. They tell you the Annual Rental Income (NOI) is $100,000. What is a fair price to offer on this asset?
Sale Price = NOI/ Cap Rate
Sale Price = $100,000/ 7.0% Cap Rate
Sale Price = $1,428,571
*The net operating income is the (expected) annual income generated by the property and the cap is determined by market averages.