In evaluating investment real estate, the ratio of the first year net operating income of a property relative to its purchase price — otherwise known as the “cap rate” — offers a useful and quick measure of a property’s financial performance. As a rule of thumb, some investors tend to correlate above market cap rates with better returns and lower risk.
In comparing the cap rate of a particular investment property to the overall market cap rate, it’s also important to consider a number of risks to determine whether the higher cap rate warrants increased investment risk. Here are three risk factors to evaluate:
Location: First consider the general and specific location of the property relative to its peers in a particular property class as indicated by area quality, property visibility and access and zoning flexibility. Location factors tend to be more demanding for retail, office and multi-family properties than industrial properties.
Leasing risk: Consider the quality of the income stream as defined by lease length, credit quality of tenants, level of tenant specialization and the property’s rental income relative to current market rates. Some absolute NNN single tenant income properties tend to require longer lease rates and distinct location advantages to compensate for the specialized nature of their tenant base, while multi-tenant commercial properties benefit from being more generic in nature to overcome the vacancy risk that correlates to shorter lease terms.
Physical attributes: Consider the physical quality of the property in terms of functionality, age and construction. Aging buildings or poor construction can be remedied to create value. But attributes that reduce functionality — insufficient parking or lack of access — can’t be solved.
As a general rule, properties with strong locations, excellent lease attributes and relatively few functional deficiencies tend to trade at lower cap rates than those with higher risk factors. Consequently, investors who focus solely on higher cap rates without regard to risk factors neglect to consider the viability of existing tenants or the future likelihood for securing replacement tenants and buyers to maintain or increase value.