§ 20A.08 Capitalization Rates

• Jurisdiction: United States
• Publication year: 2022

§ 20A.08 Capitalization Rates

Individuals in the real estate industry, including the net lease sale-leaseback industry, often quote capitalization rates, or "cap rates" for short, when valuing and comparing income-producing real properties.¹ Having at least a basic understanding of cap rates is therefore highly desirable for any lawyer representing a party in a net lease sale-leaseback transaction.

A cap rate is generally expressed as a percentage and is the quotient of the net operating income (or earnings) of the real estate divided by the purchase price (or value).² So, for example, if the purchase price in a net lease sale-leaseback transaction is $10 million and the net operating income to the buyer-landlord from the lease rents is $400,000, the cap rate for the transaction would be 4%. This also means that the purchase price (or value) of the real estate can be calculated by dividing the net operating income of the real estate by the cap rate.³

The numerator of a cap rate —net operating income—is the difference between gross income and operating expenses. Gross income in the context of a net lease sale-leaseback transaction means generally the aggregate amounts paid by the seller-tenant under the lease—both "base rent" paid to the buyer-landlord for its own account, as well as all amounts paid by the seller-tenant as "additional rent" such as taxes, insurance premiums, and utilities.⁴ Such "additional rent" paid by the seller-tenant under the terms of the lease does not usually materially impact the calculation. It is both added to gross income and subtracted as operating expenses, unless there are provisions in the lease, such as limits on such "pass-through" items, that mean that the buyer-landlord is obligated to pay some portion of the expenses of the real property, i.e., that the lease is not fully "net."⁵ Other operating expenses, such as management fees, may be relevant as well, depending on the specific buyer-landlord and specific transaction.⁶

Although useful in certain contexts, a cap rate is a simple calculation that excludes many variables that can, and usually do, impact the overall return of the buyer-landlord. The calculation applies to the value of the real estate, and therefore not the actual equity investment of the buyer-landlord (i.e., it does not take into account that a portion of the purchase price may be debt rather than equity).⁷ In addition, the concept of "operating expenses" does not take into account interest payments on buyer-landlord's acquisition...