Cap Rate vs Cash Yield in a DST: Why They Differ and Which Matters

The cap rate measures the building and the cash yield measures your equity, so they answer different questions

The OCC's commercial real estate lending handbook describes direct capitalization as estimating value by dividing NOI by a cap rate, appropriate when NOI is stabilized. Turned around, NOI divided by the price paid is the purchase cap rate. It ignores how the purchase was financed and what it cost to raise the money.

The cash yield in a DST memorandum is a different fraction. Under Rev. Rul. 2004-86 the trustee distributes all available cash less reserves in proportion to each investor's interest, so the numerator is what is left after the lender, the sponsor's fees and the reserve. The denominator is everything investors paid, which a filed purchase agreement says includes the compensation and fees payable to the trust and its affiliates.

This page bridges the two inside a single offering. Comparing a DST's yield with the cap rate on a net-lease building you might buy yourself is a separate exercise, covered at DST cash yield vs direct NNN cap rates.

Walk one hypothetical DST from a 6 percent cap rate to its cash yield, one wedge at a time

Hypothetical: a trust buys a building for $20 million with NOI of $1.2 million, a 6.0 percent cap rate. With no debt and no load, an investor's cash yield would equal the cap rate. Every figure below is illustrative; run your own numbers with your CPA.

Add the load. If commissions, offering and closing costs add $1.6 million, investors fund $21.6 million for the same $1.2 million of income, and the all-cash yield falls to 5.6 percent.

Add a $10 million loan at 5.0 percent, interest only. Debt service is $500,000, equity falls to $11.6 million, and $700,000 of cash on that equity is 6.0 percent. Take out reserves of $60,000 and sponsor and trust fees of $30,000 and the projected distribution is $610,000, or 5.3 percent of equity.

Change only the loan terms. Amortized over 30 years at 5.0 percent, debt service is about $644,000 and the yield after reserves and fees is about 4.0 percent. Interest only at 6.5 percent, debt service is $650,000 and the yield is again about 4.0 percent.

• Cap rate: 6.0 percent.
• All cash, after the load: 5.6 percent.
• 5.0 percent interest-only loan, after reserves and fees: 5.3 percent.
• 5.0 percent loan amortizing over 30 years: about 4.0 percent.
• 6.5 percent interest-only loan: about 4.0 percent.

Leverage helps only while the cap rate beats the loan constant, and interest-only periods flatter the comparison

The loan constant is the annual debt service divided by the loan. On an interest-only loan it equals the interest rate; on an amortizing loan it is higher because principal is repaid. When the cap rate is above the constant, each borrowed dollar earns more than it costs and the cash yield rises; when it is below, borrowing lowers your yield while still adding risk. In the hypothetical, 5.0 percent interest-only is positive leverage, 30-year amortization at 5.0 percent is already slightly negative, and 6.5 percent interest-only is clearly negative.

The OCC handbook warns that interest-only terms can raise debt service coverage early but increase repayment risk at maturity, and that coverage should be tested as though the loan amortized. A filed DST loan agreement does exactly that, computing its coverage ratio on a 30-year amortizing basis even though monthly payments are interest only. Find the year amortization begins in your offering; the coverage side is at debt service coverage in DSTs, and rate exposure at DST leverage and interest-rate risk.

The handbook also defines debt yield, NOI divided by the loan amount, as a measure independent of interest rate, amortization and cap rate. In the hypothetical it is 12 percent. It is a quick check that the loan is sized to the building's income rather than to a low rate.

Which number matters depends on the question: the cash yield for income, the cap rate for price and risk

For your income, the cash yield is the relevant number, with three caveats. It is a projection that can fall or stop if rent drops or costs rise; it is a distribution rate, not a return, because it says nothing about what the property sells for; and part of a distribution can be a return of your own capital. The difference between yield and return is at DST yield vs total return.

For price and risk, look at the cap rate. Compare it with recent sales of similar property and ask whether the sponsor's price included a mark-up; one REIT's Form 10-K says its DST fees are funded partly through purchase price mark-ups of the properties' estimated fair value. A low purchase cap rate means a high price, and the OCC notes that rising interest rates can push cap rates up and values down without any change at the property.

Then look at the gap. A cash yield well above the cap rate means much of your income comes from cheap or interest-only debt, which changes when the loan does. A cash yield close to the cap rate on a low-leverage trust means the income comes mostly from the building. The full line-by-line read is at how to read a DST pro forma.