Given the years of inflation, high Fed interest rates, and economic volatility, triple net lease investors have been asking us here at Westwood for advice, trying to guess where cap rates are heading, and wanting to know if NNNs are still viable investments. As always, we do our best to educate and avoid conjecture. We focus on what’s happening right now and look at historical data that might point to a particular pattern, and advise our clients based on their unique goals.
To help commercial real estate (CRE) investors understand current cap rates and market trends and make informed decisions, in this article we answer: What the cap rate is, how it’s calculated, and why it plays a vital role in assessing NNN investments.
What is Cap Rate?
The capitalization rate, or cap rate, is a formula used to determine the expected rate of return on a real estate investment. It’s expressed as a percentage and provides a quick snapshot of a property’s profitability relative to its purchase price.
As of January 2025, the average cap rate for triple net lease (NNN) properties is 5.5-7%. This is an increase from 5.25% in May 2022.
No matter where average cap rates sit, triple net cap rates can range greatly based on the location. For example, some investment-grade properties in overlooked states, such as Missouri and North Dakota, can have higher cap rates than the more popular, high-demand areas, such as Florida and Texas, yet the majority of NNN lease properties are corporate-guaranteed, long-term leases with low risk, just like anywhere else.
How to calculate cap rate
Terms you need to know:
Net Operating Income (NOI): A NNN lease property’s annual income after operating expenses but before debt payments and taxes.
Purchase Price: The total cost of acquiring a NNN property.
Steps to calculate cap rate
- Calculate the Net Operating Income (NOI) by subtracting the annual expenses from the annual income.
- Divide the NOI by the property’s current market value
- Multiply the result by 100 to convert it to a percentage
If a property generates $100,000 in NOI annually and costs $1,500,000 to purchase,this means the property has a cap rate of 6.67%.
Why Does Cap Rate Matter?
Assessing Profitability
The cap rate provides a clear measure of how much return you can expect relative to the investment cost. It’s a key metric for comparing different properties and determining whether the returns align with your financial goals.
What does cap rate indicate?
A higher cap rate indicates a higher rate of return, but also a higher risk
Cap rates indicate how long it might take you, the investor, to recoup the amount you invest in a property.
Evaluating Risk
Cap rates are also an indicator of risk. Generally:
- Higher Cap Rate: Indicates higher risk but potentially higher returns (common in less stable markets or with less creditworthy tenants).
- Lower Cap Rate: Reflects lower risk and more stable returns (common with high-credit tenants or in prime locations).
In the case of triple net lease properties, the cap rate does play a critical role in the overall internal rate of return (IRR) but also includes a number of other factors, such as the tenant, location, depreciation, and lease terms, which typically include rent escalations over the course of ten to twenty years. Also, there are zero landlord expenses when you own absolute triple net lease properties. Other types of commercial real estate may offer 7.00% to 9.00% cap rates, but when you calculate actual risk, management, and expenses, your income and IRR can be greatly reduced.
Market Insight
Cap rates vary by location, property type, and market conditions. They can signal trends in the real estate market:
- Falling cap rates may suggest a competitive market with rising property values.
- Rising cap rates might indicate declining demand or higher perceived risk.
Understanding Property Value
Investors use the cap rate to estimate a property’s market value based on its income potential. If you know the NOI and desired cap rate, you can calculate the property’s estimated value:
When buying an absolute triple net lease property with cash, cap rates compare the purchase price of the property to the income (rent) it generates. Therefore, your ROI is simply the cap rate, or rent received, as there are typically no landlord expenses with absolute NNN lease properties.
Factors Influencing Cap Rates
- Location: Properties in prime areas typically have lower cap rates due to higher demand and stability.
- Tenant Quality: Creditworthy tenants with long-term leases lower risk, resulting in lower cap rates.
- Lease Structure: Triple-net leases, where tenants cover taxes, insurance, and maintenance, often have more favorable cap rates.
- Market Conditions: Economic trends, interest rates, and real estate demand influence cap rates.
What is Cap Rate Spread?
When understanding cap rate you must also understand the cap rate spread, which is the difference between the aggregate nationwide cap rate and the current interest rates offered by lenders. Cap rate spread estimates the incremental difference in returns expected from your commercial real estate investment over risk-free bond returns.
Right now, the 10-year treasury bond is around 4.6%. Banks will build in a spread between the 10-year treasury and the loan interest rate, for instance, 1.75%. So, if the property you want to buy has a cap rate of 5.6%, the spread would be 1.00%.
As cap rates increase and the spread widens, the greater the potential increase in your overall cash-on-cash (CoC) return. This can help you decide what cap rate you need to meet your financial goals.
How to Use Cap Rates in NNN Investing
Cap rates are essential in the NNN lease market, where long-term leases and creditworthy tenants create stable income streams. When evaluating properties:
- Compare Similar Properties: Use cap rates to compare properties within the same market or asset class.
- Align with Goals: Determine your risk tolerance and target returns. A lower cap rate may suit conservative investors, while higher cap rates might appeal to those seeking higher returns.
- Look Beyond the Number: While important, cap rates shouldn’t be your sole consideration. Analyze tenant quality, lease terms, and location to ensure a comprehensive investment decision.
Cap Rates: What’s Next?
Commercial real estate cap rates are a cornerstone metric in real estate investing, offering a quick and reliable way to assess profitability, risk, and market trends.
Advertised cap rates for reliable NNNs tend to be lower than gross lease real estate because there is less risk. There are also fewer expenses and less maintenance, and, when you purchase a NNN lease property, you own a tangible asset that can be sold at any time.
However, as a metric, cap rate is most powerful when used alongside a full evaluation of the property’s potential and market conditions. Absolute triple net lease cap rates are only one measurement of an investment’s risk and profit potential, and often have little to do with the actual IRR, which can range between seven and nine percent once all factors are calculated.
It is no secret why successful investors diversify with dependable, income-producing net lease real estate to hedge against inflation and stock market swings. Triple net lease properties are a profitable, worry-free investment that often become more valuable during times of inflation.
If you’re new to NNN investing or looking for expert guidance, the team at Westwood Net Lease is here to help. We’ll assist you in understanding cap rates, analyzing properties, and finding the investment that’s right for you.
Our buyer representation is free. Call us at 314-997-5227.
