Why is having a high cap rate risky and low is safe?
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High cap rates mean that investors are not willing to pay high prices for the property? Why are investors willing to pay so little for the property? It is because the risk is high.
We call this concept the risk yield premium. To take on riskier and riskier assets...whether in real estate, bonds, stocks, then investors demand a higher yield premium to take on the riskier asset.
In lower risk assets, investors are willing to pay more money for safety, so as they bid up the price, the cap rate is lower in the lower risk assets.
Its helpful to think about it in terms of bonds.
A 2 year treasury is lower risk than a 30 year treasury, so under normal conditions the yield on the 2 year bond is lower than a 30 year bond.
Us Treasury bonds are lower risk than corporate bonds so they will yield lower. Microsoft is lower risk than a junk bond, so it yields lower than a junk bond but more than a treasury.
- Russell Brazil
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