The cap rate is a measure used to compare different real estate investments.
Often referred to as the “Cap Rate’, the capitalization rate refers to the measurement of one’s principal investment in real estate- providing a tangible description of said investment’s strength. The cap rate describes a particular investment through a percentage of the investor’s return which can be compared to another form of investment such as government bonds. Capitalization rates illustrate the strength of your investment and helps you to understand what mitigating factors (such as taxes, insurance, and maintenance) will impact your return on investment. The cap rate itself is calculated by dividing the net income of your investment by the appraisal value of the property.
When understanding the capitalization rate, one must understand the real estate market and how property appraisals may drastically skew one’s cap rate year-to-year. For instance, if you were to purchase a property at $1 million and netted $100,000 in income in your first year, your investment would hold a cap rate of 10%. Note that a typical treasury bond returns 3% in interest annually and is considered the most secure form of investment.
Now suppose that your property is appraised at $1.16 million the next year while your net income remains the same. Your cap rate will have dropped to 8.6%, a decline of 1.4% from the prior year. If the appraisal value were to decrease to $800,000 and the net income was to stay the same, your cap rate would increase to 12.5%. This illustrates the potential uncertainty with any real estate investment. Understanding your cap rate helps to quickly identify your annual ROI.
By understanding your capital rate, you are able to course-correct when appraisal values change. By building in rental rates in conjunction with changing appraisal values, investors can more easily adjust for safe investing rather than aggressive investing. This form of secure investing is gained through a Net Lease.
Net Leases provide for investment security through adjustable lease rates that an investor might find appealing. Depending on the type of net lease, the property owner can feel more secure in knowing that a certain level of cash flow will persist throughout the life of the lease. In return, the renter is usually provided with a reduced rental rate in comparison to the traditional market.
In order to assure certainty in the market, net leases will require the renter to be responsible for one of three bills: property taxes, building insurance, and/or maintenance costs. Net leases are categorized from single to triple and require the renter to foot the bill for one to three of the costs. Most commonly, a single net lease requires payment of the property tax, a double the payment of property and insurance, and a triple covers all three costs.
The triple net lease provides for the most security, usually the longest lease terms with a minimum of 10 years, but provides the lowest ROI overall. In most instances, triple net leases are used for freestanding properties, while double net leases are used in instances of one building with multiple tenants (i.e. strip malls). Singular net leases are less common and used primarily in rare commercial lease agreements.
In the end, though net leases provide for secure streams of income, they must also provide enough incentive to the renter to validate a net lease in place of a traditional gross lease. Though an investor may prefer a triple net lease, a single or double net lease can act as a compromise point for both parties. It is important to note that the cap rate should not be used as a “be all” investment decision as it does not take all circumstances into effect.
In closing, it is up to the investor to decide if the removal of the burden from property management and stable income of a net lease outweighs the profitability and potential uncertainty of gross lease terms.
Galveston County is an attractive target for an investment property as the county continues to grow year-over-year in density with annually increasing traffic counts. Major expansions to Interstate 45 and State Highway 146 will propel expansionary efforts along our frontage roads and in our major communities. This trend has extended from our northern border of League City and Friendswood to the southern coasts of Hitchcock and La Marque and continuing on to Galveston Island.
Contact our office to learn more and to be put in touch with our cities’ proper investment channels.