How high does an area cap rate have to be before it's a red flag?

Question

A VERY GENERAL rule is that nicer neighborhoods with higher appreciation tend to have a lower cap rate while less desirable areas with low appreciation tend to have a higher cap rate. That said, when looking at the cap rates for a specific area, is there a point where you get concerned at how high it is? I've found plenty of areas where the average cap rate stands at 12-14%, but they tend to have high crime.

Additionally, could high cap rates in dangerous areas be worth it if the strategy is buy and hold investing? With a property manager and good insurance, if the numbers work out as far as cash flow is there a situation where it should be done?

Additionally, could high cap rates in dangerous areas be worth it if the strategy is buy and hold investing? With a property manager and good insurance, if the numbers work out as far as cash flow is there a situation where it should be done?

Russell Brazil · Answer

Cap rate is an indication of the risk of the underlying asset and/or market. There is no such thing as a cap rate that is too high, or too low.  There is merely the risk tolerance and goals of the investor measured against the risk of the asset.

I have a relatively low risk tolerance, so Im much more attracted to deploying my capital into 4% cap rates. I wouldnt touch a 12-14% cap rate property like you mentioned. But other people who have higher risk tolerances will, and can do just as well as I do at a 4% cap rate.

Ive been saying it a lot lately...Yield is a measure of risk, not a measure of return. That goes for any asset class, real estate, bonds, dividends etc.