Risk Profile: Returns on all investments (real estate or not) are directly proportional to risk. A treasury bonds, which are guaranteed by the full faith of the US Government, have a low return and one of the lowest investment risks, and is backed by the US Government's entire credit. However, junk bonds have a higher risk rating and are subject to higher returns but have a higher chance of default. They are also "junky". A low cap rate (less that 5%) in real estate often indicates a lower risk profile. Conversely, a higher rate (greater then 7%) can be considered a more risky investment. An investor's opinion on a cap rate is directly related to their perception of the investment's potential return and risk. A Class A 98% occupied multifamily unit in San Francisco may be offered for sale at the 3% cap rate. The investor considers this a "good" rate. A Class C single tenant office located in Richmond, Virginia is available at 100% occupancy and 8%. They are both correct in that they reflect different risk profiles and desire for higher risk and higher returns. As real estate investors, the question is: "Does this cap rate reflect my willingness to take the risk, all things considered?
Asset Type: It also affects the cap rate and how it is set. This is directly tied to historical performance and risk. Multifamily assets are more likely to have low default rates, and a larger amount of capital, due to the availability of loans by government agencies (Fannie-Freddie-HUD), to help with affordable housing. Multifamily assets are more likely to have lower cap rates because of their high performance and the necessity for people to have a place they can call home. As they are subject to higher default rates and underperform when the economy's doing poorly (i.e. Hotels are considered a riskier asset type because they have higher default rates and often underperform when the economy is not doing well (i.e. people don't travel as much for work or vacation). Hotel assets are more risky than other asset types. Therefore, the cap rate for hotels could be higher and the prices lower than those of multifamily assets.
Deferred maintenance: How much deferred maintenance affects an asset's overall quality. A high level of deferred maintenance may make it difficult for an asset to be eligible for market rents. For example, a Class B multifamily investment with an 1980s vintage roof might be receiving market rents. However, it may need a new roof at a cost $500k. Another multifamily asset of the same class is located in the same location. The same vintage was used, but the roof has been completely renovated over the past 6 months. This asset is now beginning to rent at market rents. While the first asset seems to have a solid 12 month operating record, there is a significant capital outlay ahead. This will be costly and could potentially impact tenants as well as increase vacancy. Although the net operating income appears lower for the first asset, it is still highly desirable. However, there are no capital expenditures going forward. Prospective buyers may be less likely to consider the asset's caprate if it has a significant deferred maintenance expense. When comparing assets, the buyer might consider the return on investment (stabilized net operational income divided by purchase price plus any improvements). This will help determine which asset is best.
Time: The cap rates for investments can also change with the macro-economic and micro-economic conditions on the local and national markets and the timing and value of the real estate market cycle. If the economy is healthy, consumer spending tends to increase when there is job growth and consumer trust. Strong macroeconomic inputs have a significant impact on all aspects of commercial real property. These include the capital available to finance and buy properties, as well as the actual assets - office space to locate employees, industrial (space that houses the goods people want), retail (space that allows them to buy the goods), and multifamily (space for employees to live). Strong economic conditions can positively impact all these areas. If the economy isn’t doing well, commercial property tends to experience downturns. The interest rate is an economic indicator. In an economy that is growing, rising interest rates are an attempt to reduce inflation. The cash flow from commercial properties is less likely to support mortgage debt. Commercial real estate buyers who use leverage are more likely to accept lower offers. Rising interest rates are usually a sign of a strong economy. However, when rates rise, prices for commercial property tend to drop and cap rates tends to rise. A market's cap rates will fluctuate over time depending on what the economy is doing. This includes the local economy where the most spending and jobs are. It is worth noting that buyers might want to look at historical cap rates trends to assess whether current cap rate trends are appropriate in historical context. Specifically, will the buyer be willing to purchase an asset where cap rates have been lower than they were in the past. They may need to be aware that markets are unpredictable and the cap rate could rise in the future. This may also depend on how the asset's rents appreciate. If the cap rate increases, the property's price may drop.
Lease Strength: This determines the strength of a lease. Terms include length, rental rate and concessions, as well as rent increases or escalations. Penalties for breach and default provisions. Tenants also have obligations (such paying property taxes, insurance, maintenance) and financial strength. A 5-year lease with Google as the sole tenant and 3% annual rent increases and a guarantee by the parent company is a very different risk profile from an office building housing 50 tenants. They are also more likely to have small lawyers, mortgage companies and insurance companies. Google's strong corporate balance sheet would have likely allowed it to negotiate a lower per-square foot rate, lower rent increases and more attractive terms that smaller tenants. Google's financial strength means that the lease it has may be less risky to a buyer than a building with other smaller, less financially secure tenants. Strong leases of any asset type, whether multifamily, commercial, industrial, or office, will impact the property's risk perception. This will likely lead to a lower cap rate which in turn leads to a higher property value.
Location is one of the most important factors that affect a property’s cap rate. In real estate, it is the old saying, "location, place, location", that is what matters. This sentiment shows the importance of location in determining an asset's worth. A market like San Francisco2 is more desirable than one like Baton Rouge because it has more jobs, commerce and transportation. A market that has more demand leads to higher property values. For example, the cap rates for San Francisco are lower than those in Baton Rouge and the property values in San Francisco is much higher.
Asset Class: Each property type has three "classes". These denote the property's level of finishes and the strength of the tenants. This directly affects the rental rates. A property classified as "Class A", is the highest quality asset. It can command the highest rents and have the best tenants from a balance sheet and creditworthiness standpoint. The "Class A" property is the middle of the pack, receiving average rents and quality tenants. The last property in the class is a "Class B" property. This property is the least quality and thus receives low rents and tenants with low creditworthiness. Class A properties have the lowest cap rate and highest value, while Class C properties has the highest cap rate and lowest values. Class B properties, on the other hand, have cap rates that are between Class C and Class C and cap rates that are in the middle of Class A and C. The cap rates represent the asset's risk, real or perceived. To determine whether a caprate is "good", it's important to understand and compare the asset's quality to other assets in a comparable set.