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.
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.