The cap rate is essential when planning an investment in commercial real estate on a triple net lease basis. At the same time, the cap rate cannot always be reliably determined. This is because the information from various markets is incomplete. In addition, it often does not entirely correspond to reality.
What is the cap rate?
It is a ratio of the value of a property to the income it can generate over a year. Cap rate allows the investor to evaluate the prospects of investing money in a particular asset. There are several types of such indicators. By analyzing each of them, one can better understand the characteristics of the cap rate.
Choosing the property with the highest capitalization rate
When selecting a real estate object for investing money, preference should be given to those with the highest capitalization rate.
In addition, it should be noted that without considering such a rate, it is impossible to predict the effectiveness of the investment and evaluate the object before its purchase. Therefore, it is also required to conduct a market analysis and track critical economic indicators based on available data on investments in real estate.
Characteristics of the index
What is a good cap rate for NNN? For example, the risk-free cap rate involves investing in assets with at least a guaranteed return on the invested funds. As far as we know, risk-free investing is virtually non-existent. In this case, we mean such investments for which the probability of unpleasant accidents is reduced to zero.
Investors are the first to feel the business’s low profitability of investing their own money in securities. But not only but this type of financing is also accompanied by risks. For example, real estate is traditional and one of the most reliable investing methods. Nonetheless, it is also subject to risks such as low liquidity, wear and tear in the operation process, and changes in law, including tax law.
Why it is essential to determine the actual value of a triple net lease property
Appealing to an independent appraiser before renting an item for a triple net lease is a voluntary decision of the landlord or tenant. Note that by law, the valuation of the rental rate is mandatory if the subject of the lease/tenancy agreement is state or municipal property.
An independent assessment is designed to:
Find a “balance” between tenant and landlord;
make the terms favorable to both.
The rents should not be unfairly high for the tenant and sufficient for the landlord. Otherwise, the financial interests of both parties will not be met.
The main approaches and methods of triple net lease valuation
In estimating triple net lease values, appraisers use three basic techniques based on:
It predicts the income generated by using the property for commercial purposes – the income approach.
The comparative approach is compared with the terms of the triple net lease in similar properties in the region.
The calculation of costs would have been when the acquisition of an identical real estate – cost approach.
The appraiser’s task is to choose and combine approaches to get an objective result.
The comparison method with analogs is based on comparing situations of triple net lease objects with similar utility. It is based on the following principle: a tenant will not pay more rent than another tenant pays for a similar thing.
The calculations are preceded by an appraiser collecting information about similar transactions. This method is recognized as the most popular in triple net lease valuations. The approach is applicable in situations where you can find objects identical to the evaluated subject of the contractual relationship. However, if the thing is unique, applying the comparative approach is limited or impossible.
The subject of lease relations may be different objects of real estate: land, buildings, premises, and others. Their purchase, improvement, and repair to the triple net lease involve certain costs. The owners are interested in reimbursing these costs. The “Classical” situation of the cost approach is as follows: calculate the number of the expenses for the acquisition and reconstruction of a similar real estate object.
However, the evaluation of rents by the cost approach has its characteristics – they are associated with the specifics of the evaluated object. No landlord will agree to rent out the thing at a rate that would not provide a return of capital. The calculated amount would guarantee the return of expenses not at one-time payment (as in the sale, for example), but when it is broken down to a certain period, equal to the duration of rental relations.
The method of recapitalization and economic depreciation is used within the framework of the cost approach.
In assessing the market rental rate, the recapitalization method aims to establish such a value in which the owner’s expenditures on the property would have been laid down. This approach is used for cost recovery.
Depending on the goals set for the appraiser, the specialist may use one of the varieties of rate-of-return accounting when calculating the recapitalization factor: the Ring, Inwood, or Hoskold method. To determine it, the appraiser needs to analyze the characteristics of the appraisal object, the current state, and the degree of depreciation.
When calculating by the economic depreciation method, an independent evaluator determines the degree of the leased object depreciation (both moral and physical depreciation are considered). The calculation of the market value of a triple net lease is carried out by taking into account wear and tear. It also finds all the landlord’s costs for the maintenance of the leased property.
The income approach
It is applied to non-residential premises that are used for commercial purposes. The appraiser is based on the income forecast and implemented through two methods – the capitalization of income and discounted cash flow. The application of the income approach in the valuation of triple net leases is controversial among experts.
Its unique feature is that it prioritizes the interests of the tenants. According to the appraiser, a reasonable renter will not agree to rent payments for a length of time that would surpass his revenue from the use of rented premises or land. The appraiser’s role is to compute the payment of a typical tenant using a triple net lease, in addition to analyzing the rental property.
How Is Cap Rate Calculated on NNN Lease?