May 19, 2021

The Ins and Outs of Cap Rate for Contractors

Many contractors build and build but never get to the easy part of construction: owning that well-built piece of property and collecting rent. Those that do try their hands at real estate ownership often get caught in the trap of buying residential rental properties and encountering troubled tenants who can’t or won’t pay their rents on time.

Commercial rental properties with established tenants and long-term leases (for 10 years or more) tend to be much more stable investments, so it pays to learn how to approach buying them. Let’s look at how contractors can use capitalization (CAP) rates to establish commercial owner-lessor profitability for a purchasing decision.

An objective comparison

In most cases, you can determine the CAP rate of a commercial tenant lease property by taking the annual rent and dividing it by the purchase price of the building with the tenant in it. Knowing how to determine CAP rates is helpful because so many other variables exist that it can be daunting to even consider acquiring such properties.

True to their name, commercial tenant lease properties are those in which the tenant doesn’t live there. Stores, malls, warehouses and manufacturing plants are all commercial tenant lease properties. Apartment buildings, duplexes and rental homes are residential lease properties.

Using the CAP rate properly gives a contractor-buyer the chance to compare one property to another without becoming overly involved in what kind of tenant is occupying the building. This can be a confusing distraction. You can compare an auto store, pharmacy, private school or entertainment complex using the same metric — CAP rate — to make the commercial property purchasing decision a little easier.

NNN leases

Here’s an example: a commercial building with a tenant currently paying $194,000 a year in rent hits the market (with the tenant in it) for $3.104 million. That would be a CAP rate of 6.25%, assuming the property is a triple net lease. Otherwise, net operating income should be used instead of rent in the CAP rate calculation.

A triple net lease (also known as a “NNN lease”) is one under which the owner isn’t responsible for any costs of maintaining the building. The tenant must pay for anything that goes wrong and needs repair, as well as any costs of maintaining the inside or outside of the building to the perimeter of the property.

Under a triple net lease, the tenant is responsible for establishing and maintaining full schedules of capital repair and replacement costs and making sure building components are kept up and replaced when necessary — even though you own the building. Once you’ve bought a property with a triple net lease, you should incur zero out-of-pocket costs and have little need to communicate with the tenant.

This type of purchase is generally “turnkey” in that you invest the money and then simply collect rent. Chasing after a delinquent tenant or going to small claims court to collect or evict are relatively rare occurrences when the commercial lease tenant is a nationally known chain restaurant or well-established pharmacy and drug store franchise. However, check with your CPA regarding the tax implications of holding a rental property of this size and type.

Other terminology

There is such a thing as a double net lease. This is one in which the roof and structural components of the building are the owner’s only required maintenance and repair costs. The tenant retains responsibility for all other maintenance and repair costs.

Under a double net lease, the tenant makes and maintains contracts with repair, maintenance and landscape vendors to maintain the property. In this case, it’s a good idea for the property owner to retain 3% of the purchase price in a reserve or contingency account to provide for future repair or replacement costs of the roof and structural components.

Another common point of confusion among those deciding whether to buy a commercial lease property with a tenant is the lease type. A “fee simple” lease is one in which the owner owns both the land and the building. A “leasehold property” is one in which the land is owned but not the building. Be sure you’re clear on all the terminology involved before signing on the dotted line.

Take it slow

If you’re considering buying a commercial tenant lease property, don’t rush into it blindly. Work closely with your professional advisors to formulate a feasible, financially sound approach to the purchase decision.

How to get started buying commercial properties

So, the notion of buying a commercial rental property with established tenants intrigues you but you’re not sure how to get started. You could (and should) start slowly by consulting an experienced commercial real estate agent or attorney. In many locales, there are also real estate ownership groups that meet regularly to discuss topics such as tax law updates and innovative cash management or financing strategies.

If you already own multiple residential buildings, a good way to approach buying your first, say, $3 million to $4 million commercial tenant rental building is to “trade up.” Doing so may be feasible through a like-kind exchange or similar arrangement, which should be carefully investigated with the help of your CPA and attorney. Sometimes the mortgages of “traded up” residential properties can be paid off under the new purchasing transaction, and the new property can be valued higher because of appreciation of the properties being relinquished.

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