This article will give you an overview of the factors that can impact how an investor determines what a good cap rate should be in any market or asset.
Risk profile: All investments, real estate or otherwise, have returns that are directly related to risk. The return on a treasury bond is relatively low because it is guaranteed by the US Government's full faith and credit and has one the lowest risk investments. Junk bonds, on the other hand, are more likely to default because they have higher risk ratings, and offer higher returns. A lower cap rate (less than 5% in real estate) often indicates a lower risk profile. However, a higher caprate (greater than 7%) is often considered to be a more risky investment. A cap rate is an indicator of how much the investor considers the investment's return to be "good". An investor might choose to buy a Class A 98% occupied multifamily property in San Francisco at a 3% cap, which they consider a good cap rate. Or, a Class C single-tenant office in Richmond, Virginia, which is being offered at 100% occupancy at an 8% cap rate. Both investors are correct, they reflect a different risk profile and desire to take on higher risk with higher returns or lower risk. Real estate investors should ask themselves the following question: "Does my cap rate reflect the risk that I am willing and able to take?"
Time: Investment caps can change depending on the macro- and microeconomic conditions in each market. Also, the timing of valuations in the real estate cycle will affect the cap rates. Consumer spending increases when the economy is doing well. This is usually due to job growth and consumer confidence. A strong macroeconomic environment has a direct impact on commercial real estate. This includes the availability of capital to purchase and finance properties and the actual assets such as office space (space to find employees), industrial space (space to store the goods people want), retail (space to buy them in the marketplace), and multifamily (space where employees can live). A strong economy can have a positive impact on all of these. Commercial real estate can also suffer from downturns if the economy isn’t performing well. Inflation is also a key economic indicator. When interest rates rise, it's because the government wants to keep inflation under control in a growing economy. Because commercial property cash flows can support less mortgage debt, buyers who leverage commercial real estate tend to offer lower prices. A rising interest rate environment is often an indicator of a strong economic situation. However, commercial real estate prices tend to cool when interest rates rise. Cap rates tend to increase. The cap rate of a market will fluctuate depending on the state of the economy, especially in the local market where spending and jobs are most important. Buyers may be interested in reviewing historical cap rate trends in a particular market to determine if current cap rates make sense within a historical context. For example, is the buyer looking to buy an asset in a place where cap rates are lower now than in the past? Markets are always changing so buyers may want to think about the possibility that the cap rate will rise in the future. Depending on the appreciation rate for the asset's rental income, it could lead to a decrease in property value.
Real estate investors often ask the question, "What is a good rate of return?". There is no one universal cap rate. It depends on many factors. We will also discuss how we define "good". If you are fed up with the "it depends" answer, the broker package contains information about potential cap rates that could be used to purchase an asset. This includes comparable sales rates. This should be viewed with caution as some assets might be cherry-picked, and not all assets are comparable.
Asset Type: This determines whether or not a cap rate will be "good". It is also directly linked to risk and historical performance. Multifamily assets have lower default rates and more capital available due to loans from government agencies (Fannie/Freddie, HUD), which support affordable housing. Multifamily assets have lower cap rates than other asset types due to their strong performance and the need for people to live in a home. Because of their higher default rates, hotels are more risky than other asset types. They also often perform poorly when the economy isn't performing well. People don't travel as often for work or pleasure, and they are less likely to be in demand. Hotels are considered a more risky asset type than multifamily assets in the same market. This could lead to a higher cap rate and lower price.
Also, cap rates don't take into account debt. Other return metrics, such as cash-on cash returns or internal rate of return (IRR), should also be calculated as they provide a wider picture of the potential.
An investor should always invest in property with a higher caprate, as it will forecast a higher yield.