How Cap Rates Work in Net Lease
What a net lease cap rate measures, what moves it, why it is not a total return, and how to compare cap rates across deals fairly.
What a cap rate measures
A capitalization rate is the first-year net operating income divided by the purchase price. Because a true NNN tenant pays nearly all operating costs, NOI in net lease is usually close to the annual base rent. A building leased at $150,000 per year that sells for $2.5 million trades at a 6.0% cap rate.
The cap rate is a pricing convention, not a return forecast. It tells you the income yield at purchase before financing and before any rent increases, capital costs, or sale proceeds. Two properties at the same cap rate can produce very different total returns.
What moves net lease cap rates
Tenant credit is the most visible driver: investment-grade corporate guarantees price tighter than unrated franchisee guarantees. Remaining lease term matters nearly as much, because short term creates renewal risk. Rent growth matters too, since a lease with regular increases produces more income over time than a flat lease.
The real estate also shapes pricing. Strong trade areas, high traffic counts, good access, and rent at or below market all support lower cap rates. Finally, interest rates set the backdrop. Net lease buyers compare yields with Treasuries and borrowing costs, so rising rates generally push cap rates up, though the relationship is neither immediate nor one-for-one.
Normalizing cap rates before you compare
Headline cap rates are often not comparable. One listing's NOI may assume the landlord pays nothing, while the lease actually leaves roof and parking lot replacement with the owner. Adjust NOI for a realistic reserve for any retained obligations, and for any management, vacancy, or non-reimbursed costs.
Also compare like terms. A 6.5% cap rate on a lease with four years remaining is not cheaper than a 6.0% cap rate on a lease with 15 years. Some investors look past the cap rate to an unlevered internal rate of return that models rent bumps, a holding period, and a conservative exit cap rate.
Cap rate vs. cash-on-cash and IRR
Cash-on-cash return is annual pre-tax cash flow after debt service divided by the equity invested. With leverage, cash-on-cash can be higher or lower than the cap rate depending on whether the loan constant is below or above the cap rate. When borrowing costs exceed the cap rate, debt reduces current yield, a situation often called negative leverage.
The internal rate of return captures the whole hold: purchase price, annual cash flows, rent growth, capital costs, and sale proceeds. For long-term net lease holds, small changes in assumed exit cap rate can move IRR significantly, so test a range rather than relying on one number.
Frequently asked questions
Is a higher cap rate better?
Not necessarily. A higher cap rate means more income per dollar today, but it usually reflects more risk: weaker credit, shorter term, flat rent, landlord obligations, or a weaker location. The right question is whether the extra yield fairly compensates for those risks over your expected holding period.
How do you calculate a net lease cap rate?
Divide the first-year net operating income by the purchase price. In a true NNN lease, NOI is usually the annual base rent less any costs the landlord bears, such as reserves for roof or structure. For example, $120,000 of NOI on a $2,000,000 price is a 6.0% cap rate.
Why do interest rates affect cap rates?
Net lease income behaves somewhat like a bond, so buyers compare it with Treasury yields and their own borrowing cost. When rates rise, buyers need higher property yields to justify the investment, and financing becomes less accretive, which usually pushes cap rates up over time.
What is an exit cap rate?
An exit cap rate is the assumed cap rate at which you sell the property at the end of your holding period. Underwriters usually assume an exit cap rate equal to or higher than the going-in rate, because the lease will have less term remaining and the building will be older.
Educational content, not tax, legal or investment advice.