When Purchasing Triple Net Leased Properties,
What Else Should You Take Into Consideration Besides The Cap Rate?
Whenever investors are looking to purchase triple net leased properties, one of the first things they look at is the cap rate. Real estate investors frequently use cap rate as one of the primary selection criteria for a property as it displays the return. Nevertheless, the cap rate independently does not relate the entire story about investment return.
Let’s take a deeper look at two triple net investment properties: the 1st property is Advance Auto Parts @ 8% cap and the 2nd triple net property is a IHOP @ a 7.25% cap rate:
#1 The Advance Auto Parts is priced at $2.8 Million with a 70% LTV at 7.25% interest with a total loan amount at $1,960,000.
#2 The IHOP is also priced at $2.8Million with a 70% LTV at 6.25% interest rate with a total loan of $1,960,000.
| Advance Auto Parts | ($28 M @ 8% cap) | IHOP ($28 M @ 7.25% cap) |
| Net Operating Income | $224,000 | $203,000 |
| Loan amount | $1,960,000 | $1,960,000 |
| Down payment | $840,000 | $840,000 |
| Loan interest | 7.25% | 6.25% |
| Annual Interest payment | $142,100 | $122,500 |
| Income before tax | $81,900 | $86,250 |
| Investment equity return | 9.75% | 10.26% |
| Appreciation rate year | 1% per year | 3% per year |
| Appreciation value | $28,000 | $58,800 |
| Total return before depreciation | 13.08% | 17.26% |
While the Advance Auto Parts suggests a higher cap rate than the IHOP, the return of equity on the IHOP is approximately the same as the Advance Auto Parts. This is because the IHOP has a lower interest rate 75 basis points. You might be wondering why the IHOP has such a lower interest rate? There a numerous factors that influence the interest rate such as:
- Total Mortgage : When borrowing money from a bank on your house, the rule of thumb is “the greater the down payment, the less the interest rate”. However, loans for triple net real estate the opposite is true. If you were take a loan of $300,000 your rate might be 8.5%, but if you were to take a loan of $2,000,000, your rate could be as little as 5.5%. It works the same way in any business, when you buy in bulk, there is a discount.
- Triple Net Property Type : There are many types of triple net leased properties available to investors. A single tenant bar will obviously have a much higher interest rate than an established retail center with strong tenants. The bank knows if that bar ever goes out of business, it’s going to be much more difficult to rent out or sell than a multi-tenant upscale retail shopping center in a good location. Apartment complexes will generally have lower interest rates than even a high credit triple net property due to the fact that banks understand that everyone needs a home to live and therefore it much easier to resell or release.
- Age of the Property: Newer triple net properties will have a lower mortgage rate verses an older property. The risk factor for older properties is greater, therefore the interest rate increases.
- Location of the Triple Net Investment: The demographics of the quality of real estate play an important factor in the interest rate. If the triple net leased property is located in Naples Florida with an average household income of over $100,000 verses a declining crime infested area in Miami, the banks will demand a higher interest for the property in the less desirable neighborhood. Additionally, besides the neighborhood location, lenders take into account the immediate neighbors of the property. Is the center surrounded by national tenants or local shops?
- Credit of the Tenant: A “Fortune 500″ triple net property such as Best Buy, CVS, Walgreen’s and Home Depot to name a few will demand a lower rate verses a local mom and pop tenant.
- Your track record : If you have strong credit, your interest rate will go down.
- All lenders are different. If you shop 5 different lenders, you will most likely receive 5 different rates which could vary as much as 1 point apart. Using a mortgage broker will typically get you much better terms as they have close relationships and the lenders know they can’t take advantage of them.
- Prepayments : Having the ability to prepay your loan on your triple net lease property will cost you more. Simply by agreeing to lock in for the full duration of the term of the loan the rate will dramatically decrease, often as much a 1 point.
- Environmental Risks: Applying for a mortgage loan on a retail center with a gas station will most likely result in paying a higher rate since there is a greater risk of leakage contamination;
Triple net investments will appreciate at different rates. When the real estate appreciation is included into the return, even at a modest 3% rate, the IHOP in our above example has nearly a 33% higher return than the Advance Auto Parts, 17.26% vs. 13.08%. Below are some common causes that may effect the appreciation of a triple net property:
- Property Location: Triple net leased properties situated on a prime location, e.g. in front of a power center, right off a busy interchange, has a much greater chance of appreciating in value.
- Age of Property : A recently built building will generally appreciate more rapidly than a 50 year old property.
- Demographics: Certain areas of the United States are known for their consistent growth, such as Florida, Georgia, California, Arizona…Also the higher the average household income and population density the greater chance of appreciation.
- Triple Net Lease Rent: What is the market rent and what is the upside potential. If the present tenant is only paying $10 psf and the market rent is $12, there is upside potential when the lease comes for renewal. Does the tenant have a flat triple net lease for 20-25 years or are there annual bumps? This is also plays a large factor in appreciation as higher revenue results in a greater property value.
- Supply and Demand: A buyers market, ie. there are more buyers than willing sellers resulting in higher appreciation.
- Inflation: Raw materials for construction increase each year because of inflation. Labor costs also rise because of inflation.
As you can tell from above, there is multiple factors that must be taken into account when purchasing triple net lease properties. Do not rely on your own limited knowledge. Just as you go to eye specialists, CPA’s, Financial Planners and Attorneys, you should use an ‘experienced’ broker with a track record that specializes in the triple net real estate area.
To conclude our article, the three main points that will most affect your return are:
· Cap Rate
· Interest Rate
· Property Appreciation