When making a buying decision, many commercial real estate (CRE) investors analyze the cap rate to interest rate spread (also known as the cap rate spread), their cash flow related to debt service, and how both will influence their return on investment. But how important are these figures when investing in triple-net (NNN) lease properties?
Let’s look at a rundown of each and how they could play into your NNN investment strategy.
Cap Rate Assessment
Many new and seasoned CRE investors assess a property’s advertised cap rate to determine if an investment presents a level of risk they are comfortable with and offers a good return. A higher cap rate means larger ROI but may indicate a bit more risk. A lower cap rate means less ROI and potentially lower risk.
Keep in mind, the advertised cap rate is calculated on an all-cash basis and is just one measure of the equity return on investment, as many other calculations and variables can affect the outcome – one of which is the cap rate spread.
Cap Rate & Interest Rate Spread
Put simply, the “cap rate spread” is the difference between the aggregate nationwide cap rate and the current interest rate being offered by lenders. It is a measure of the risk-and-reward premium for CRE investing. If the spread widens, investors are more highly rewarded, indicating a higher demand for investment properties.
Knowing the interest rate and cap rate available on a particular asset, you can estimate a “spread” or the incremental difference in returns expected from your CRE investment over risk-free bond returns. This spread is meant to compensate CRE investors for the additional risk assumed by taking on debt.
Cash flows from most real estate are typically expected to grow, unlike a government bond with fixed interest payments. As such, in your analysis to calculate your overall rate of return, future growth rates are an important component to underwrite into your investment. Higher growth in net operating income (NOI) can lead to larger spreads over the fixed interest rate, thus increasing overall cash-on-cash (CoC) return.
The cap rate/Treasury yield spread mathematically explains the trade-off in returns that CRE investors are willing to accept for higher-risk versus lower-risk investments. But does this apply to NNN investments?
What Does the Cap Rate Spread Mean for a NNN Investment?
Though the cap rate spread is a barometer for CRE investor sentiment, most absolute NNN lease properties are not directly and immediately influenced by movement in interest rates. These tenants operate with 10- to 15-year leases with no landlord expenses or costs associated with them, and the cap rate, NOI, and any built-in increases are set throughout the base term and option periods of the lease.
Historically, no matter what the economy is experiencing, triple-net property investments are known to be the least risky of the CRE market. Most are leased to investment-grade tenants who guarantee to pay rent per a long-term, in-place lease. These companies also typically provide essential, recession-proof goods and services. This reliability lends itself to consistent cap rates in the range of 5.00–7.00% and a potential internal rate of return (IRR) that rivals other types of investments (8-10%).
Despite interest rates hovering at all-time lows for years, minor rate increases, and fears of rate surges, cap rates have not changed dramatically in decades. This allows us to confidently satisfy both the most conservative and aggressive NNN lease investors.– Jason Simon, VP Westwood Net Lease Advisors
Cash Flow Related to Debt Service or Debt Yield
When obtaining debt to purchase a NNN property, to forecast cash flow related to debt service, or “debt yield,” lenders will ensure the property’s income (NOI) covers its operating expenses and debt payments by about 1.25 times (which is the debt service coverage ratio – DSCR).
Therefore, to figure the debt yield, lenders will use NOI as a percentage of the total loan amount (debt yield = property NOI/loan amount). For example, a NNN property with a $100,000 NOI collateralizing a $1 million loan generates a 10 percent debt yield. Theoretically, debt yield is the return your lender would receive if it were to foreclose on your property on day one.
The debt-yield ratio helps balance a value that may be inflated by low cap rates, low interest rates, and high leverage. It removes subjectivity, helps lenders navigate an inflated market, and provides insight into how wrong things can go before the lender won’t be made whole on its investment. – Dan Konecny, Colorado Real Estate Journal
To Wrap it Up – Cap Rate Spread & Debt Yield for NNN Investments
If you are just beginning your NNN property search and plan to obtain debt to purchase:
- Start by looking at the advertised cap rate for the level of risk associated with the property.
- Then determine the NOI (rent received) and divide that by the loan amount you’re seeking (debt yield), and you will get a feel for whether the property is a good investment that fits the lender’s criteria and your objectives.
- The cap rate spread has little effect on NNN investments, other than a lower interest rate being beneficial to your internal rate of return (IRR) and asset value.
An easier way to determine if a particular asset fits your criteria and the lender’s requirements is to engage a Westwood Net Lease Advisor. We get to know you and your goals, do all the necessary calculations, and represent you from the pre-property search all the way through closing, at no cost to you.