Cap Rates Explained: How a Sale-Leaseback Is Priced

A cap rate is the ratio of a property's net operating income to its purchase price or current market value. Net operating income, usually shortened to NOI, is the income a property produces after operating expenses and before debt payments, depreciation and income taxes.

In a sale-leaseback under a triple net lease, the tenant pays the building's operating expenses directly, so the investor's NOI is close to the base rent you pay. That makes the arithmetic unusually clean:

• Cap rate = annual net rent divided by price.
• Price = annual net rent divided by cap rate.

The first version describes a deal that has been agreed. The second is how an investor arrives at an offer. It starts with the rent the lease will pay and the cap rate it requires for a deal with your characteristics, and the price falls out of the division.

The following is hypothetical, for illustration only. The rent and cap rates are round numbers chosen to make the arithmetic easy. They are not market data and do not indicate where any property would price.

Suppose a company will pay $500,000 a year in net rent under its leaseback.

• An investor requiring an 8 percent cap rate would pay $500,000 divided by 0.08, or $6,250,000.
• An investor requiring a 7 percent cap rate would pay $500,000 divided by 0.07, or about $7,140,000.
• An investor requiring a 6 percent cap rate would pay $500,000 divided by 0.06, or about $8,330,000.

Same building, same rent, same tenant. The price differs by roughly two million dollars across the three investors purely because each requires a different yield. This is why a small difference in cap rate matters so much, and why showing a property to more than one type of investor can change the outcome.

The example also shows the inverse relationship that confuses people at first: the lower the cap rate, the higher the price. A seller wants the lowest cap rate it can obtain.

A cap rate is a compact statement of how risky the investor thinks the income is and how much it expects that income to grow. Lower rates are associated with prime locations, newer buildings and strong tenants. Higher rates are associated with older buildings, secondary locations, the risk of a single tenant leaving and economic uncertainty. In a sale-leaseback the main drivers are these:

• Tenant credit. The investor is relying on one company for all of the income. Stronger finances and a longer record support a lower cap rate.
• Lease term. A longer committed term gives the investor more certain income.
• Rent increases. Scheduled or inflation-linked increases raise future income and can support a lower starting cap rate.
• Expense structure. The more building costs the tenant carries, the more passive the investment.
• The real estate. Location, condition, age and how easily another tenant could use the building all bear on what the investor holds if you leave.
• How critical the site is to your operations. A facility you cannot easily leave is a safer bet.
• Rent relative to market. Rent well above what a replacement tenant would pay makes the income look less durable.
• Capital markets. Cap rates do not move in lockstep with interest rates, but they tend to rise when rates rise, because higher borrowing costs reduce what buyers can pay.

Some of these you cannot change. Others you can, and they are discussed below.

Because price is rent divided by cap rate, there are two ways to raise the price. One is to obtain a lower cap rate, which is a real gain: the same rent buys you more proceeds. The other is to agree to pay more rent, which is a trade: you receive more today and pay it back, with increases, over the term.

Sellers sometimes focus on the headline price without noticing which lever produced it. Before comparing offers, work out the cap rate each one implies by dividing its first-year rent by its price. Two offers with the same price can be very different deals if one assumes much higher rent.

A higher price from a lower cap rate is found money. A higher price from higher rent is an advance you repay as a tenant. Always ask which one you are looking at.

Owners also use the cap rate as a rough gauge of what the capital costs, by comparing it with the interest rate on a loan. It is a reasonable starting point, with two cautions. Rent typically rises over the term while a fixed loan payment does not, and at the end of a loan you own the building while at the end of a lease you do not. The cap rate measures the property's operating yield on day one. It is not the full cost of the transaction.

Cap rate is a useful measure and an incomplete one. It reflects a single year of income against price. On its own it does not capture future capital expenditures, what happens when the lease expires, growth in rent, or the effects of financing. Two offers at the same cap rate can differ in ways that matter far more to you as the tenant:

• How fast the rent rises.
• How long you are committed and what your renewal rights are.
• Who pays to replace the roof or the mechanical systems.
• How freely you can alter, sublet or assign.
• How likely the buyer is to close without asking for a price reduction.

Treat the cap rate as the first number you look at, not the only one.

1. Present the company well. Organize several years of financial statements and explain any weak periods before the investor asks.
2. Offer a lease term that matches how long you truly intend to stay. Do not shorten it out of caution if you plan to be there anyway.
3. Set rent at a level a replacement tenant would also pay, so the income looks durable.
4. Resolve property issues early: environmental questions, title defects, deferred maintenance.
5. Document why the site matters to your operations.
6. Take the opportunity to several categories of investors, since each has a different required yield.
7. Compare the implied cap rate, rent and lease terms of every offer side by side.

This is the evaluation and negotiation work TAG does for the seller: establishing what the property and the business can support, then creating competition among investors so the cap rate reflects the strengths of the deal and the lease remains one the company can live with.