Evaluating Cap Rates and Tenant Credit

Understanding Cap Rates

The capitalization rate (cap rate) is the most widely used metric for valuing net lease properties. It represents the relationship between a property's net operating income (NOI) and its purchase price:

Cap Rate = Annual NOI / Purchase Price

A lower cap rate indicates a higher price relative to income (and generally lower perceived risk), while a higher cap rate indicates a lower price relative to income (and generally higher perceived risk or shorter lease term).

What Drives Cap Rates?

Tenant Credit Quality

Investment-grade tenants (BBB- or higher from S&P, Baa3 or higher from Moody's) command the lowest cap rates because the risk of lease default is minimal. A CVS or Walgreens property with 15 years of lease term might trade at a 5.5% to 6.5% cap rate, while a regional tenant with the same lease term might trade at 7.5% to 9%.

Lease Term Remaining

Longer lease terms mean more predictable cash flow and lower risk for the buyer. A property with 15 years remaining will trade at a tighter (lower) cap rate than the same property with 5 years remaining. As leases approach expiration, cap rates typically widen to reflect renewal risk.

Rent Escalations

Leases with built-in rent increases (typically 1% to 2% annually or 5% to 10% every five years) are more valuable than flat leases. Escalations protect against inflation and provide growing income over time.

Location and Market

Properties in major metro areas with strong population growth and high barriers to entry command lower cap rates than properties in rural or declining markets. However, higher-cap-rate secondary markets can offer compelling risk-adjusted returns for investors willing to look beyond primary cities.

How to Assess Tenant Credit

• Public credit ratings: Check S&P, Moody's, or Fitch ratings for the tenant or parent company
• Revenue and profitability: Review the tenant's annual revenue, net income, and debt levels
• Store performance: If available, assess whether the specific location is a strong performer for the tenant
• Industry outlook: Consider whether the tenant's industry is growing, stable, or contracting
• Lease guarantor: Is the lease guaranteed by the parent corporation or only by a subsidiary or franchisee?