Understanding Cap Rates and their role in §1031s & DSTs~ Part 2

March 27, 2025

By Al DiNicola, AIF®
1031 Tax Deferred Exchange Specialist & DST Advisor/Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC, Member of FINRA/SIPC

In Part 1, we did an overview of understanding cap rates in their roles in 1031 exchanges as well as Delaware statutory trusts. In this part, we will dive a little deeper into the effects of cap rates over the period of ownership and how it may affect the exit or disposition of the real estate. Click this link to see Part 1. Understanding Cap Rates Part 1

There are several items and issues that may affect the investment. The net operating income or NOI of the property during the term of ownership may fluctuate. Individual investors simply take the rent rolls or rental income the previous owner of the property had and used that as a basis for projecting income over their ownership of the property. Sponsors of Delaware Statutory Trust, or DST will utilize a process that includes projections or proformas as they are known when developing a new property. For example, if a sponsor is acquiring a brand-new apartment complex, they will typically project a period on how long it will take to lease up the property. This projected “lease up” period may be anywhere from 18 to 24 months or longer. During that lease up the operating income will increase as more and more units are rented by individual tenants. Individual investors that buy existing rental properties or investment properties will hopefully experience renewals of leases to maintain their net operating income. Over the years many investors as well as sponsors have projected a spread between an increase in operating expenses and rent increases. An example may be operating expenses increasing 3% per year and rent increases 5% per year.

There are items that will affect this net operating income, specifically expenses. Operating expenses may expand or contract that will directly affect the “net” operating income. When an individual investor purchases a property, the local municipality may reevaluate the value of that property and increase the value which will have a direct effect on taxes due on that property. There have been several incidents where we have heard from investors whose property taxes have increased over a one-to-two-year period of owning the property. On the residential side, we have had investors in Florida who have purchased the property from a seller who owned the property as their primary residence. In Florida residents enjoy a designation called homestead exemption. That homestead exemption limits the amount of increased valuation year over year to 3%. This directly affects property taxes. When a new investor purchases the property, the valuation could increase drastically. Especially if the new investor is purchasing it as a rental property. The valuation of the property may be based on the sales price that the new investor has paid. The property as a homestead may have enjoyed years of only a 3% increase. We have seen the valuation double. There could be a 50% year-over-year increase in taxes. Many times, new investors do not anticipate this recalculation of the value of the property that’s being purchased.

Typically, sponsors will project increases in property valuations, especially in the case of a newly built multifamily apartment complex. However, there have been municipalities in several states that have increased valuations (above normal projections), which will have a direct impact on increased taxes. There are several petitions currently challenging the increased valuations.

Current Stress on Assets

There are a few asset classes including multifamily that are experiencing (what some experts suggest is temporary) is cap rate expansion. The rise in interest rates over the past few years as well as the number of new multifamily apartments being built and delivered is putting stress on ca rates. The rise in operating expenses (taxes & insurance) and the flat rental increases are causing the stress. The good news on the supply pipeline is that by mid-2025 there appears to be a dramatic reduction in future supply.

Cap Rate Compression vs. Expansion

Cap Rate Compression: Occurs when property values increase while NOI remains stable, reducing the cap rate. This often happens in low-interest-rate environments or when investor demand is high.
Cap Rate Expansion: Happens when property values decrease or NOI declines, leading to a higher cap rate. Rising interest rates, economic downturns, or oversupply of properties can drive expansion.
Remember- lower cap rate may increase value or price. There is an inverse relationship.

The Role of Cap Rates in §1031 Exchanges

A §1031 exchange allows investors to defer capital gains taxes by reinvesting proceeds from a sold property into a “like-kind” replacement property. Cap rates are crucial in evaluating replacement properties within the §1031 exchange process.

Current Market Trends & §1031 Exchanges

1. Rising Interest Rates & Cap Rate Expansion

With the Federal Reserve tightening monetary policy, borrowing costs have increased, leading to cap rate expansion across many asset classes. Investors selling properties purchased during a low-rate environment may face lower valuations on their replacements.

2. Shift in Investor Demand

While demand remains strong for high-quality assets like industrial and multifamily properties, certain sectors, such as office and retail, have seen cap rate expansion due to uncertainty and structural shifts in demand.

3. DSTs as a Potential Solution in a Volatile Market

Delaware Statutory Trusts (DSTs) provide an alternative investment option for §1031 exchange investors looking for diversification and stability in uncertain times. DSTs offer fractional ownership in institutional-quality real estate, managed by professional sponsors.

In a rising interest rate environment, investors may find it challenging to locate suitable replacement properties with favorable cap rates. DSTs allow investors to access pre-vetted properties with stabilized returns, reducing the risk of failing to complete a §1031 exchange within IRS timelines.

DSTs also offer a passive investment structure, removing the burden of active management, which can be appealing in an unpredictable real estate market.

However, investors should carefully evaluate each DST offering, including sponsor experience, underlying property performance, and potential risks. DST investments are subject to specific risks and may not be suitable for all investors. Consulting a financial professional is recommended before making investment decisions.

Key Considerations for §1031 Exchange Investors

Monitor Cap Rate Trends: Understanding whether cap rates are compressing or expanding can impact property valuations and investment decisions.
Evaluate NOI Growth: Properties with strong NOI growth potential may offset cap rate expansion concerns.
Consider DSTs for Diversification: DSTs can provide access to institutional-quality real estate and passive income potential.
Act Quickly in a Volatile Market: With shifting cap rates, §1031 exchange investors must be proactive in identifying replacement properties within IRS timelines.
Consult a Financial Professional: DSTs and other §1031 exchange options should be considered based on individual investment objectives, risk tolerance, and financial goals.

NAMCOA® is a SEC registered investment advisory firm that provides comprehensive portfolio management, financial planning, and fiduciary decision-making services on behalf of retirement plan sponsors. Our Difference is summarized by our fiduciary approach which enables us to better meet portfolio and retirement plan objectives, resulting in stronger risk adjusted returns for investors and peace of mind for Clients. We also focus on alternative real estate investment. Many real estate investors are seeking tax deferred solutions utilizing §1031 exchanges or Opportunity Zones.

DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your §1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC §1031 Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 5 Centerpointe Drive, Ste. 400 Lake Oswego, OR, 97035. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

Thank you

Understanding Cap Rates and their role in §1031s & DSTs~ Part 1

March 23, 2025

By Al DiNicola, AIF®
1031 Tax Deferred Exchange Specialist & DST Advisor/Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC, Member of FINRA/SIPC

We review countless numbers of Delaware Statutory Trust (DST) offerings on a weekly basis. Included in the materials are references to acquisition cap rate and fully loaded cap rate. We will attempt to clarify in a two-part series.

What is a Cap Rate

The capitalization rate, or cap rate, is a key metric used in real estate to measure the expected rate of return on an investment property. It is calculated as Cap rate is equal to the net operating income divided by the current market value.

For example, if a property generates $50,000 in annual net operating income, or NOI and is valued at $1,000,000, the cap rate is 5%. Cap rates have provided investors somewhat of a “Rule of Thumb” when comparing multiple properties. Different asset classes will or may have a range of cap rates. Cap rates enable an investor to assess different types of properties. A lower cap rate may indicate a lower risk and potentially a more stable investment. Higher cap rate could indicate a riskier investment, however, with the potential greater return.

Delaware Statutory Trust (DST)

A DST is a legally recognized trust that allows investors to own fractional interests in real estate assets.
Often used for 1031 exchanges, allowing investors to defer capital gains taxes when selling real estate.
Managed by a sponsor, so investors have no active management responsibilities.
Typically, it holds institutional-grade commercial real estate like apartment complexes, office buildings, self-storage, industrial and other asset types.

How Cap Rates Apply to Investments and DSTs:

Lower Cap Rates: DSTs usually offer stable, income-generating properties with lower cap rates (typically 4%–6%), reflecting the lower risk of these institutional assets.
Market Influence: Cap rates for DSTs vary based on property type (multifamily, industrial, retail, etc.), location, and interest rate environment.
Trade-off: Lower cap rates often mean higher property values but lower relative returns for investors.

One of the items investors need to understand is the difference between the purchase price cap rate and the fully loaded cap rate. Investors will evaluate the current investment property they are purchasing. In addition, there are costs to acquire that property. Which may change the cap rate. When an investor looks at a property to acquire, the cap rate when negotiating the sale may change once the property is acquired. Will all the current tenants remain in place? How long are the remaining leases? NOI is prior to debt service (if any) on the property. The investor buyer will have additional cost involved in the acquisition of the property or cost of sale items. This includes commission, closing cost, etc. This would be a fully loaded cap rate.

Here is an example of a Purchase Price Cap Rate vs. Fully Loaded Cap Rate.

Purchase Price- Calculated by dividing the first year proforma net operating income of $185,917by the purchase price of $2,920,500. Calculated as 6.37%

Fully Loaded-Calculated by dividing the first year proforma net operating income of $185,917 by the Total Cost to acquire of $3,671,752. Calculated as 5.06%

SIDE BAR-There is an inverse relationship between the cap rate and purchase price. A lower cap rate typically indicates a higher purchase price.

Capitalization rates (cap rates) are influenced by several factors, including:

1. Interest Rates

When interest rates rise, cap rates tend to increase because investors demand higher returns to compensate for higher borrowing costs.
When interest rates fall, cap rates tend to decrease, making real estate investments more attractive.

2. Market Conditions

A strong economy with high demand for properties can lower cap rates as property values rise.
A weak economy or oversupply can increase cap rates as property values decline.

3. Property Type

Different property types (e.g., multifamily, office, industrial, retail) have varying levels of risk and return, leading to different cap rates.
More stable, lower-risk property types (e.g., multifamily) often have lower cap rates, while higher-risk properties (e.g., hospitality, specialty retail) tend to have higher cap rates.

4. Location

Prime locations with strong demand, good infrastructure, and low crime rates generally have lower cap rates.
Secondary or tertiary markets with higher risk or lower demand typically have higher cap rates.

5. Risk Perception

Properties with stable long-term leases and creditworthy tenants typically have lower cap rates.
Properties with higher vacancy risk or short-term leases tend to have higher cap rates.

6. Rental Income Growth

Properties in areas with high rental growth potential generally have lower cap rates.
If rental income is stagnant or declining, cap rates may increase.

7. Property Condition & Age

Newer, well-maintained properties typically have lower cap rates due to lower maintenance costs and higher desirability.
Older properties with higher capital expenditure requirements often have higher cap rates.

8. Supply & Demand Dynamics

If demand for real estate investments is high, cap rates decrease due to competition.
If supply exceeds demand, cap rates rise as property values drop.

9. Investor Sentiment

In a bullish market, investors may accept lower cap rates due to confidence in future growth.
In a bearish market, investors may demand higher cap rates as compensation for increased risk.

Conclusion

Cap rates play a crucial role in evaluating real estate investments and are especially relevant in the 1031 exchange process. With current market conditions showing signs of cap rate expansion, investors should stay informed, assess their options carefully, and consider alternatives like DSTs to navigate the changing landscape successfully. Given the complexities involved, working with a qualified financial professional can help ensure an informed investment strategy that aligns with financial objectives and risk tolerance. Part Two will explore cap rate compression and expansion.

Thank you.