Why do some people say higher Cap rate means lower demand?

Question

Hello everyone. Newbie from CA here. I’ve seen multiple comments by others on these forums where they state that a high CAP rate just means low demand. This seems as if it over simplified this concept but can anyone shed some light on this topic?

I live in LA and any CAP rate you’ll find is below 1%.

Heath Ryans · Answer

@Adrian Jenkins Cap rates are usually an indicator of demand for an asset in a certain location. People are willing to pay more and get a lower return for an asset that has a greater chance of continue to produce income and appreciate. The more likely the chance that asset could stop producing income and the lower chance of appreciation, the higher the cap rate. That means you would get a higher return for a "riskier" investment.

A quick search for properties in LA, even on Loopnet, reveals an average cap rate of roughly 3%. Ranging between 1% and 6%.

Mike Dymski · Answer

Cap rate is how the market values an income stream.  Buyers place values on income streams based on all kinds of stuff (alternatives, interest rates, money supply, economic conditions, confidence, risk, location, supply, asset type, upside potential, demographics).

Art Perkitny · Answer

@Adrian Jenkins, as the comments above have already stated, cap rate (or any return metric for that matter) will usually correlate with various risk metrics.

In the case of demand, we can look at vacancy rates for rental units to gauge if the market has high or low demand.

If we then compare the median cap rate for each location within each vacancy rate cohort between 0.8% and 16.3% we get this:

As you can see, at very low vacancy rates (i.e. high demand) cap rates are rather constricted.

Whereas the vacancy rate increases so does the median cap rate.

The data above was collected from the census american community survey and is computed at the tract level.

Vacancy rates where computed first and split into cohorts that increment 0.1 percent. I then queried the data-set for each cohort and computed the median cap rate based on 50 percent of annual median rents divided by the median home value for each respective census tract.

I then filtered the data set for cohorts with 100 or more samples to eliminate any potential outliers.

Link to Raw Data CSV

Jay Chang · Answer

Generally speaking, a fast-growing regions like Los Angeles or San Francisco have low CAP rates. People are willing to pay more in these areas because these regions are growing fast. In other words, investors are willing to sacrifice consistent cash flow in return for future appreciation, which isn't realized until the property is sold.

On the contrary, the properties with high cap are located in areas associated with low-growth, which has less demand relatively. The demand is lower because of their low-growth, not because of the high cap.

If you find a high cap property in a fast-growing region, then the demand for that property will be extremely high. For example, a 7% cap multifamily property in Los Angeles with lots of value-add opportunities... People will be bidding for this property left and right.

Hope this helps!

Adrian Jenkins · Answer

Thanks for the feedback. Seems as you are from the area as well. Would you say purchasing a condo with no hopes of the value increasing, or not really being concerned about it, simply to have it paid off by a tenant is an investment that is worth it?  Some condos in certain areas are almost 1 to 1 with the mortgage payment and market rent at the moment.

Michael T. · Answer

@Adrian Jenkins a higher CAP does not mean it's a bad investment it just means there is going to be a different strategy to making money besides cash flow.  In the Los Angeles market there are not a lot of properties that are above a 5 CAP.

Quite often the only times I'll look at the CAP rate is if I'm dealing with commercial properties otherwise stick to IRR for 1-4 units.

Joe Splitrock · Answer

As others have said CAP rate measures risk, but expected appreciation is also a main driver.

That is because rental property has two main investment aspects, cash flow and appreciation. When people invest in low CAP rate, they are often expecting higher long term appreciation. High CAP rate indicates more cash flow over time and less expected appreciation.

It is not that one investment is better than the other, but rather two different ways to make money.

Syed H. · Answer

Cap rates measure risk not demand

Adrian Jenkins · Answer

@Wayne Brooks

Great example. Seems as you are from Florida. Have you been to or lived in Jacksonville?

Wayne Brooks · Answer

Cap rates, just like bond yields, are also an indicator of risk....Long term T Bills-low rate, junk bonds-high rate.

Why do some people say higher Cap rate means lower demand?

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