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Measuring Cap Rates in Build to Suit Development

Steady income, not having to deal with management issues, and solid tenants make build to suit triple net (NNN) leases very attractive for investors interested in diversifying their portfolio with a stable investment.

And one of the most common and important ways these build to suit NNN lease properties are valuated is by using capitalization rates. 

More commonly known as the “cap rate”, this is the ratio of the net operating income a property generates to the purchase price of the property.

How NNN leases are structured helps determine just how attractive and valuable those properties are, and thusly creating the property’s cap rate.

How should those rates be calculated in a build to suit development? Several factors that influence cap rates in a build to suit development include construction costs, lease type, historical cap rates, and regional economics.

 

Construction Costs

In a build to suit development, where the agreed upon rental rate is fixed, so are the construction costs. And those construction costs are built into, and ultimately help determine the rental rate.

Construction costs have risen in recent years due to increased material and labor prices, resulting in bumps in rent and thus impacting the net operating income (NOI) and ultimately the cap rates for new build to suit projects.

 

Lease Type

Lease types can vary in how big a role the rent in a build to suit lease will play in determining the NOI of a property.

Those lease types can vary from triple net, double net or single net. Each will play a role in rents, operating expenses, NOI and other financial factors that will ultimately impact cap rates.

 

Econometric Analysis and Historical Cap Rates

The need to forecast what the prevailing local market capitalization rate will be for the property type represented by the property under consideration at the anticipated time of its resale is determined in historical cap rates.

Understanding at what stage of the real estate cycle the local market is in terms of rents and prices can help investors better assess where market cap rates will most likely be headed in the years in the short and medium-term.

 

State-specific/regional economics

Economic policies and economic growth of different cities and states can have a major impact on property valuations. This includes states with no income tax and those with strong growth rates.

People think net lease transactions are fairly cut-and-dried. That the properties and procedures involved are standard and do not vary much. In reality, net lease transactions have become far more diverse than they used to be due to lease restructures, small-cap company credit underwriting, and more creative deals.

Given the current macro-economic environment, it’s more important than ever for investors to understand both the benefits and drawbacks of using cap rates to determine which investment opportunities warrant a closer look, and which are simply overpriced relative to market comparables.

Tags: Property Values CAP Rates

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