A cap rate is the first number everyone quotes on a small retail center. Andrew Danner explains how he checks the NOI, leases and tenants behind it.
Photo: Alex Reynolds / Unsplash
I have bought, sold and brokered small retail since 2007, and the cap rate is the first number everyone quotes and the last number I trust. It is a useful shorthand. It is also the easiest number in commercial real estate to dress up.
Here is how I read one on a neighborhood center, the kind of small-bay, service-tenant property we are building at The Shops at Smithville.
What is a cap rate, in plain terms?
Cap rate is net operating income divided by purchase price. If a center earns a certain amount after operating expenses and before debt, and you pay a certain price, the ratio tells you the unlevered yield in year one. That is all it is.
- Cap rate at this price
- 7.50%
- Price at your target cap rate
- $2,000,000
Cap rate = NOI ÷ price. Value = NOI ÷ cap rate. The example figures are illustrative, not the terms of any property.
Open the full calculator →In the example, the math gives you 7.5%. That figure means nothing on its own. It is only as good as the NOI on top of the fraction, and on a small center the NOI is where the work is.
How do you check the NOI behind a cap rate?
On a marketing flyer, the NOI is often the strongest year the property ever had, or a projection. I rebuild it from the leases.
- Start with rent actually being paid under signed leases, not asking rent on vacant suites.
- Subtract a vacancy and credit allowance, even if the center is full today.
- Check which expenses the tenants reimburse and which the owner absorbs. A lease that looks NNN can carry caps and exclusions.
- Add a reserve for roofs, parking lots and HVAC. Small centers rarely show one.
- Remove one-time income that will not repeat.
Ben Nelson covers this approach in his article on NOI-first underwriting. It is the right order of operations: get the income right, then argue about price.
Read Ben Nelson, CCIM, on NOI-first underwriting a retail lease.
Why do lease terms matter as much as the cap rate?
Two centers with the same cap rate can be very different investments. One has tenants with years left on their leases. The other has most of its leases ending soon, and the buyer inherits the job of renewing or replacing them.
When I look at rollover, I ask what it would cost to re-lease each suite: downtime, a tenant improvement allowance, commissions. On a small center, one vacancy is a big share of the income. A buyer who pays a low cap rate for a center with heavy near-term rollover is paying for income that may not be there.
How does tenant mix change the risk?
Service tenants that people visit every week tend to be steadier than concept retail. A wireless store, a nail salon, a pizza shop, an accountant, a trades office: those are the businesses committed at The Shops at Smithville, and that mix is a deliberate choice. A center that leans on everyday visits does not depend on one anchor to bring the customers.
I also look at concentration. If one tenant pays a large share of the rent, the cap rate should reflect what happens if that tenant leaves.
The cap rate is the headline. The leases are the story. Read the story before you believe the headline.
What about the building behind the cap rate?
A cap rate says nothing about the roof. Before I trust any number on a small center, I walk the property. I look at the age of the roof and the rooftop units, the condition of the parking lot, the drainage, the lighting and the signs. I ask for the service records. Then I put a cost and a year next to each item.
Deferred maintenance is real money. If a buyer has to replace a roof or repave a lot soon after closing, that cost comes straight out of the return the cap rate promised. On a newer center the list is shorter, which is one reason buyers tend to look harder at age and condition than at the headline rate. Either way, the building is part of the deal, and the price should reflect it.
What does a cap rate tell a developer?
When we build, the cap rate is the exit test. We compare what the finished, leased center should earn against the all-in cost to build it, and we want that yield on cost to sit comfortably above the cap rate a buyer would pay. Matthew Danner explains that spread in his article on yield on cost.
That is also why I do not quote a cap rate for Smithville or any market in an article. The right number depends on the leases, the tenants, the condition of the building and the buyers in the market on the day you sell. Anyone who gives you one number for a whole market is selling you something.
What should a buyer or a tenant take from this?
If you are buying a small center, rebuild the NOI, read every lease, price the rollover, and only then look at the cap rate. If you are a tenant, understand that the owner reads your lease the same way. A solid business on a reasonable term, in a space that suits it, is the lease an owner wants, and that gives you room to negotiate on build-out and terms.
At The Shops at Smithville we have 18,680 SF available in four spaces, from Suite 400 at 1,400 SF to the 10,000 SF South Building. The site plan and brochure are at /smithville, and if you are a broker with a client, start at /smithville/brokers.
Brokers: see the available spaces and how to bring a client.
Questions about a center you are looking at, or about a suite at Smithville? Call me at 816-612-5191. I am happy to talk through how I would read the numbers.
See the site plan and brochure, or send an enquiry.
Questions people ask
How do you calculate a cap rate?
Divide net operating income by the purchase price. NOI is the property's income after vacancy and operating expenses, before debt service and income taxes. For example, a hypothetical center earning $150,000 of NOI and selling for $2,000,000 trades at a 7.5% cap rate. The math is easy. Getting the NOI right is the hard part.
Is a higher cap rate better?
It depends which side you are on. A higher cap rate means more income per dollar of price, which buyers like, but it usually reflects more risk: shorter leases, weaker tenants, an older building or a less certain location. A lower cap rate usually reflects steadier income. Judge the rate against the leases behind it.
What is a good cap rate for a neighborhood center?
I will not quote a market cap rate in an article, because the right number depends on the leases, the tenants, the building's condition and who is buying that day. Ask for recent comparable sales from someone who closes deals in that submarket, and compare them on the quality of the NOI, not just the headline rate.
How does a cap rate relate to yield on cost?
A cap rate measures what a buyer pays for the income of a finished property. Yield on cost measures what a developer earns on what it cost to build. A project makes sense when yield on cost sits far enough above the market cap rate to pay for the risk and the time of building.
Andrew founded Windfield Real Estate, LLC in 2007 and has brokered and developed commercial real estate across the Kansas City metro since. He works with buyers, sellers, landlords and tenants across asset classes, and guides owners and tenants through every stage of development — including The Shops at Smithville on U.S. 169.
Windfield Real Estate, LLC · Licensed Missouri real estate broker · 816-612-5191 · info@windfieldrealestate.com
