what's better high or low cap rate
Below is a brief overview of factors that might affect an investor's decision about what a good' caprate should be in any given asset or market.
Asset Class: There are generally three types of property types. They denote the standard of finishes, strength of tenants, and amount of amenities. This directly impacts the rents a property can command. A "Class A" property, the most valuable asset class, is the one that has the highest rents. It also has the best creditworthiness and balance sheet. The property of "Class B" is middle of pack. It receives average rents, and average quality tenants. A property of "Class C", which is the lowest quality, has the lowest rents and tenants who have low creditworthiness. Classes A properties have lower cap rates and higher values than Class C properties. Class C properties have highest cap rates, but the lowest values. Class C properties have the highest caps rates and the lowest values. While Class B properties have cap and value levels between Class C, A, and C, they reflect the risk that an asset poses, both real and perceived. It is crucial to identify the asset's type and quality level before deciding if a caprate is "good".
Real estate investors ask often, "What is the best cap rate?". This question is actually asking, "What is the return on this investment?". For example, "If I take the cashflow of an asset and do not consider mortgage payments, then divide that amount by the purchase cost to get the capitalization (cap rate) rate, what is the desired return for a commercial realty asset that was purchased with all cash?" There is no universal cap rate and there are many factors that affect the differences in cap rates between properties. (For this discussion, we will use "good", as a term to describe favorable investments that one might make. For those who don't like the "it depends” answer, the broker packages contain information on possible cap rates. These rates are comparable to other sales. You should look at this with caution, as the assets might not be comparable and could be cherry-picked.
Below is a brief overview of factors that might affect an investor's decision about what a good' caprate should be in any given asset or market.
Asset Type: The asset type also influences whether a cap-rate is "good" or "bad". This also has a direct correlation to risk and past performance. Multifamily assets typically have lower default rates due to higher amounts of capital and the availability of loans from government agencies like Fannie, Freddie, HUD to support affordable housing. Multifamily assets typically have lower cap rate than other asset classes due to their excellent performance and absolute need to provide housing for families. Hotel assets are considered more risky because they have higher defaults rates and can often underperform in times of economic downturn. Because of their higher default rates, hotels are often less profitable in times when the economy isn't performing well. Hotels are considered to be a higher-risk asset type and therefore the cap rate and price could be higher than for multifamily assets of the same quality.
All things being equal, investors should invest in properties with higher cap rates because they are more likely to get a higher yield.
Risk profile: Returns on all real estate investments are directly related to the risk. The return on a Treasury bond, which is guaranteed by all the faith and credit of US Government, is very low. A junk bond, with a higher risk rating, higher return target, and a lower probability of default, is an alternative. A cap rate of less than 5% is often indicative of a lower risk profile in real estate. However, a cap rate greater than 7% is considered a more risky type investment. Investors will judge whether a caprate is "good", or "bad". This is because they are evaluating the return on investment against the risk. A Class A 98%-occupied multifamily home in San Francisco that is offered at a 3% rate may be purchased by an investor. This is different from a Class A single tenant office in Richmond which is offered at a 100% occupancy rate at 8%. Both are wrong. They reflect a differing risk profile and desire for lower risks and higher returns. The question real estate investors need to ask is "Does the caprate reflect the risk I'm willing to take?"
Time: Cap rates on investments change over time depending on macro and micro-economic factors in the national and local markets, and the timing for the valuation within the realty market cycle. If the economy is performing well, consumers will spend more when they feel confident and have more job opportunities. Strong macroeconomic inputs can have an impact on everything commercial realty. From the amount of capital in the market to finance properties to the actual assets, such as office (space for employees), industrial (space holding the goods people desire to buy), retail space (space in which to buy the goods), multifamily (space in which employees can live) and retail (space in which to buy them). All of these are usually positively affected by a strong economy. However, commercial real property can suffer from economic downturns when the economy isn’t doing well. Also, interest rates are a major economic indicator. If interest rates rise, this is an attempt at controlling inflation in a developing economy. This means that commercial properties have less cash flow to pay off mortgage debt. Therefore, commercial realty buyers who use leverage tend not to make higher offers. Although rising interest rates are a good indicator of a strong market, they can also indicate a cooling economy. Commercial real estate prices will tend to fall when cap rates rise. A market's cap-rate will change depending on how the economy is performing, especially the economy in the local area where jobs and spending have the greatest impact at the asset level. To help buyers understand the historical trends in cap rates in a given market, they may wish to examine the cap rates in that market in order to decide if they make sense. In other words, would the buyer like to purchase an asset in an area where cap taxes are lower than it was in the past. Markets are dynamic and buyers might want to take into account that the cap rates may rise in future. Also, depending on the appreciation of the asset’s rents, there could be a decline in property value.