Deferred Maintenance is a measure of the asset's overall quality. The asset that has high levels of deferred care may not be able to rent out its asset class at market rents. A Class B multifamily asset with a 1980s age may be eligible for market rents. However the roof needs to be replaced at a cost up to $500k. Another multifamily asset, a Class B-class, is in the exact same market. However, it has had a complete renovation over the last 6 months. Now, it is starting to get market rents. Although the first asset has a strong 12-month operating history, there is a substantial capital outlay ahead. This is expensive and could have an impact on tenants and increase vacant properties. While the second asset appears less desirable, the Net Operating income for the last 12 month is low. However, the future capital outlay will not be significant. A potential buyer will view an asset's cap rate differently if there is a significant deferred line item. A buyer may benefit from comparing both assets for a 6% caprate to decide which one is preferable.
Available Capital: Although not an influence on the cap rates of properties, it is important to consider what a "good" caprate is when buying a property. The stabilized cap rates of commercial realty should be avoided by buyers. This includes mortgages and debt. When using debt to buy or renovate property, it might be sensible to use capital that costs more per unit than the cap rates yield for a limited time. This will allow you to refinance into less expensive debt or sell the asset. If the asset's stable cap rate is less than the current interest rates, buyers should borrow less and borrow more. The debt will dilute property returns.
As shown above, there are many variables that can impact the cap rates for any asset at any point in time. It is necessary to compare the cap rate of the asset with similar assets that were on the market at that time. Also, it is important to evaluate the capital costs and other alternatives. Investors must also be honest about their risk tolerance and risk appetite. There are plenty of publicly accessible data to help determine if a cap rate for an asset is equal to the risk return of similar assets. After conducting proper diligence and accounting of variations in the property relative a comp set, it all comes down to an individual’s personal preferences and goals to determine what "good" cap rates mean.
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".
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.
Lease Strength: How strong a lease is will determine its strength. This includes the terms of it, including the length, rental rates, lease concessions and rent increases or escalates. Also, default provisions and penalties for breach. The obligations of the tenants (such as paying for property taxes and insurance) and their financial strength. Google is the only tenant in an office building. This means that it has a 5-year term, 3% annual rent escalations, and a guarantee from its parent company. It has a much different risk profile to an office with 50 tenants. Google's corporate financial strength likely means that it would have been able to negotiate a lower rate per foot, lower rent hikes, and better terms than many other smaller tenants. Google's financial strength could mean that the building with smaller and less financially secure tenants may have a lower risk profile than its lease. Strong leases for any asset type – multifamily or retail, industrial, office or commercial - will impact the property's perception of risk and lead to a lower rate of return, which could translate into higher property valuation.
The most important factor that influences a property’s caprate is its location. The old saying in real estate is that location is everything. This sentiment highlights the importance of location on an asset's value. A market like San Francisco2 offers more jobs, business, transportation, and overall economic strength than a Baton Rouge market. A market with greater demand means higher property prices. In San Francisco, for example, the cap rate is lower and property value much higher than in Baton Rouge.