Lease Strength. A lease's strength can be determined by its terms, which include the length, rental rate or concessions, increase or decrease in rent, penalty for breach, default provisions, penalties for violation, obligations of tenants (like the payment of property taxes, insurance, and maintenance) as well the financial strength of each tenant. Google, for example, is a single tenant in an office that offers a 5-year term and 3% annual rental escalations. The risk profile of an office that houses 50 tenants with small attorneys, mortgage companies, and insurance companies has a significantly different one than an office that houses 50 tenants. Google's corporate stability would have enabled it to negotiate lower rates per square foot, rent increases that are lower, and terms that are more appealing than those of smaller tenants. Google's financial strength might mean that its lease represents a lower risk profile for a buyer than if it had smaller, less financially secure tenant. Strong leases, regardless of whether the asset is multifamily residential, industrial or office, can impact the property's perceived risk. It will also likely result in lower property values and a lower cap.
Location is an important factor that can impact the cap rate of a property. Real estate's old adage is that it only matters where you are located. This sentiment speaks to the importance location has on the worth of an asset. A market like San Francisco2 has a higher number of jobs, more commerce, and overall economic strength. A market with more demand has higher property values. This means that the cap rates in San Francisco and property values in Baton Rouge are significantly lower.
Available Capital: Although this is not a factor that affects the cap-rate of a particular property, it is something to consider when deciding on a cap rate that is "good". A general rule for commercial real estate buyers is not to use any debt or mortgages that are higher in cost (includes origination fees) and lower than the stabilized property cap rate. To buy and renovate a home, you may find it more practical to use capital with a higher cost than the cap-rate yield. Then you can refinance the debt into lower-cost debt or sell the property. If the stabilized cap rates of assets are lower than the prevailing rate for the asset, the buyer might consider borrowing less and using more capital. As the debt will reduce the property’s overall returns.
Asset Type. The type of asset can also impact whether a cap rates is "good", and it is directly tied with risk and historical performance. Multifamily assets often have low default rates. They also have more capital because of the loans that government agencies (Fannie/Freddie/HUD) offer to help affordable housing. Multifamily assets generally have lower cap rates due to the asset's high performance and the fact that people need a place where they can live. Hotels are considered to be a more risky asset type because of their high default rates. Also, they often underperform when there is a slow economy. There are fewer people who travel for work and vacation, or the asset is located in a market with low demand. Because hotels are considered higher risk assets, one might expect the cap to be higher for them and the price to be lower than multifamily assets with similar market quality.
Time: Investment cap rates can change according to the macroeconomic conditions and the timing of real estate valuations. Consumer spending is more likely to rise when there's job growth and consumer optimism. Strong macroeconomic factors impact all areas of commercial realty, from the availability of capital to finance purchases to the actual assets. All these factors are often positively affected by strong economies. Or, commercial realty can experience downturns if it isn't doing well. A leading economic indicator is the interest rate. As such, an increase in interest rates can be seen as an attempt to curb inflation in a growing country. This means that commercial property buyers using leverage will often make lower offers because the cash flow from commercial property can pay less mortgage debt. A strong economy is often reflected by a rising interest-rate environment. However, prices for commercial real property tend not to rise when they rise. The market's caprate will change with time, depending on how the economy is doing. Particularly the local economy that has the highest impact on jobs and spending. Buyers might be interested to check the historical cap rate trends for a market to determine whether the current cap prices make sense in a historical context. Is it possible to purchase an investment in a market with lower cap rates than the past? Markets are highly cyclical so buyers should consider the possibility of the cap rate rising in the future. In addition, depending on the rental appreciation, they may see a decrease in the property’s value.
Deferred Care: The extent of deferred care can also impact the quality of an asset. To receive market rents, an asset with high amounts of deferred management may need significant capital. A Class B multifamily unit with a 1980s vintage roof could be receiving market rents. But, the roof will need to be replaced at a $500k cost. Another Class B multifamily investment in the same neighborhood has the same vintage. However, the property received a full renovation within the last six months and is now starting to attain market rents. The first asset is strong and has had a good 12 months of operation. However, the capital outlay for the second asset is large and will impact tenants and increase rental vacancies. Although it may appear less desirable on paper, the second asset has no additional capital cost. Its Net Operating Income is very low over the past 12 months. Prospective buyers will have a different view of the asset's caprate when there is a substantial deferred maintenance line item. It may be advantageous for buyers to calculate the return on cost (stabilized operating income divided with the purchase price plus any improvements) for both assets when comparing them to determine which one is more desirable.
Asset Class: There is generally a three-tiered system for property types that indicates the quality of finishes, tenant strength, and amenities. This has a direct impact on the rents they can get. A property that is "Class A", the highest quality, can command the highest rents. Additionally, it has the best balance sheet and creditworthiness. A property in "Class B", which is at the middle of all the pack, receives average rents with average quality tenants. Finally, a Class C property is the lowest quality property. They receive the lowest rents as well as tenants with low creditworthiness. It has the lowest cap-rates and highest values for Class A properties. On the other hand, Class C properties offer the highest cap-rates and lowest value properties while Class B properties provide cap-rates and values between Class C-Class A. These cap-rates reflect the level of risk an asset holds, real and perceived. When considering whether a rate is "good", it is important that you know the asset's class or quality level in order to evaluate how it compares to other assets within the appropriate comparative group