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GUEST POST: Cap rate and (NNN) net lease commercial real estate

Estimated reading time: 2 minutes, 51 seconds

(NNN) Net Lease Property Educational Series, Series 2: Understanding the NNN Asset

What does the term “cap rate” mean and how does it apply to (NNN) net lease commercial real estate?

In our last educational series, we explored what a NNN net lease agreement means and how it applies to commercial real estate. Next up in our educational series, we explain what the term “capitalization rate” means and how it applies to NNN net lease property.

Unlike residential real estate that is solely valued on the real estate itself, net lease commercial real estate is evaluated through a combination of factors including the length of the lease term, the credit quality of the occupying tenant and the escalations in rent over the term of the lease. The combined values of these factors are represented in what is called the capitalization rate, often referred to as the “cap rate.”

Once all combined factors of value are considered, a cap rate is assigned to the property as a market rate measurement of value. When used properly, the cap rate is a very efficient means to evaluate an investor’s cash-on-cash rate of return based on the rental income the property is expected to generate over the term of the lease, assuming an all cash investment.

The cap rate for a net lease investment property is delineated as a percentage, simply calculated by dividing the net operating income (NOI) of the property by the current market value or purchase price.  For example, if Bob buys a net lease property, all cash, for $2 million and the net operating income (NOI) generated for the first year is expected to be $100,000, the cap rate for his investment would be 5.0% ($100,000 / $2,000,000 = .05 =or 5.0%). What this means is that, for that year, Bob is generating a 5% return on his $2 million cash investment. Typically net lease investments are attached to a long-term lease so Bob, in that case, would be able to predict his rate of return on the original $2 million invested not just for the first year but over the entire lease term given a pre-determined annual NOI. For example, if in Year 5, the NOI of Bob’s net lease property is expected to increase to $115,000, then Bob’s rate of return on his original $2 million cash investment would then increase to 5.75% ($115,000 / $2,000,000 = .0575 or 5.75%).

By truly understanding what cap rate means and how it applies to net lease property, one may begin to understand the potential value that lies within this asset class.

The information provided in this guest post is for educational purposes only and should not be construed as advice of any kind.

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