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

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.

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

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:

1. 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.
2. Mar­ket Influ­ence: Cap rates for DSTs vary based on prop­er­ty type (mul­ti­fam­i­ly, indus­tri­al, retail, etc.), loca­tion, and inter­est rate envi­ron­ment.
3. 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.