Cap rate starts with normalized NOI
Before discussing yield, normalize the income and expenses. One-time reimbursements, unusually low maintenance and deferred capital can make reported NOI look stronger than the sustainable operating picture.
Tenant risk is about the income stream
Lease term, tenant credit, concentration, renewal options, rent steps, expense obligations and local replacement demand all affect the durability of cash flow.
A long lease is not automatically low risk
A lease can be long but below market, above market, difficult to assign or dependent on a tenant whose business is weakening. Read the actual lease economics.
Replacement cost is a capital question
Roof, HVAC, parking, elevators, façade, code upgrades and tenant improvements may not appear in annual operating expenses even though they materially affect ownership returns.
Do not let one metric answer three questions
- Cap rate: what operating yield am I buying?
- Tenant risk: how dependable is that income?
- Replacement cost: what capital will this property require?
Stress-test rollover
Model what happens if a major tenant does not renew, if downtime is longer than expected or if new tenant improvements and leasing commissions are required.
FAQ
Is a higher cap rate always better?
No. Higher yield may compensate for tenant, location, building or capital risk.
Should capital expenditures be in NOI?
Market conventions vary, but major capital needs should be modeled somewhere in the investment analysis even when they are excluded from reported NOI.
What is the biggest commercial underwriting mistake?
Treating current rent as permanent while ignoring lease rollover and building capital requirements.
Commercial note: Review leases, operating statements, capital history and physical condition with qualified professionals before underwriting a commercial acquisition.
