Cap Rates on Real Estate

By Rick Ormsby
Managing Director

A Cap rate is also known as a capitalization rate and is the rate of return on a real estate investment property based on the income the property is expected to generate. Cap rates are closely tied to interest rates. As interest rates decline, cap rates also decline, resulting in an increase in real estate valuations.

If you are a franchisee who owns real estate, you probably get 5-10 calls a week (or so it seems) from companies who seemingly specialize in sale-leasebacks. These companies are seeking to list your real estate for sale, attempting to sell it in a big pay-day for a lease to a future buyer.

Cap rates vary geographically, by brand, by the security of the underlying investment and also by the size of the deal. They are also dependent on the term of the lease agreement, the credit quality of the franchisee, personal guarantees and rent increases over time.

As an example, cap rates for two Burger King restaurants might be 6.75% in the Midwest and 5.50% in California. As another example, a Walgreen’s might fetch at cap rate in the 4’s while a KFC next door might be at a 7%. Why? Walgreen’s might corporately guarantee the leases, driving the cap rates to a rate that would approximate a long-term bond. The KFC could be owned by a 2-unit franchisee – a much riskier investment and would require a higher return for an interested investor.

The 1031 exchange market is a driver of competitive cap rates in the marketplace. Also referred to as a like-kind exchange, these are IRS-approved transactions that allow a seller of real estate to place the proceeds into a similar real estate investment while deferring taxes. The typical window for doing this is within 9 months of selling, so many 1031 buyers are eager to find a quick deal to avoid triggering a taxable event. The effect, when there is a bunch of buying and selling, is that 1031s can create a euphoria of sorts on the pricing of real estate investments.

On restaurant franchise deals, we typically value real estate in the middle of the country at cap rates of 6.25% – 7.00% in today’s market (highly subject to change based on primarily on interest rates). This valuation typically yields a real estate value that is higher than the business value of a franchise business (where the real estate is owned by the franchisee).

Don’t get too enamored by rumors of incredibly favorable cap rates, however. Brokers typically charge 5% – 6% fees – effectively worsening the cap rate by as much as 0.5% or more and lowering net proceeds. There is oftentimes a gap between an advertised cap rate and an actual cap rate as well. All kinds of unsubstantiated numbers fly around the marketplace so be careful.

Unbridled Capital has significant expertise in valuing real estate, assessing the best use for franchise real estate, helping franchisees to borrow money on the best terms and performing sale-leaseback transactions. We are happy to help or provide further perspective anytime.