I'm doing some basic reading about real estate, and I've come across two principles that articles tend to reiterate, but I don't understand why these principles are necessarily the case:

  1. "A larger CAP rate means a more risky investment." I don't understand why this is the case. If a CAP rate is Net Operating Income / Price of Real Estate, then you could have a market where the price of the asset is very high, possibly because of land costs (i.e. California), which seems to be a factor that would grow or shrink independently of risk. Why is a higher CAP rate seen as directly correlated with risk?

  2. "Rising interest rates mean higher CAP rates." I've seen a few articles assert that there is a correlation here, and suggest that there is a corresponding, subsequent downward effect on housing prices, but no mathematical explanation for why rising interest rates would logically translate into higher CAP rates. Why might this be the case?

1 Answer 1


Why is a higher CAP rate seen as directly correlated with risk?

Because of the general principle in finance that expected return is positively correlated to risk, meaning that higher-return investments typically have higher risk. Otherwise, people would flock to higher-return investments, raising their entry price (and lowering their returns).

You see this in real estate where lower-value properties tend to have higher returns (higher rent relative to the value) because of higher instances of default, more problems, etc. With higher rents you get more stable tenants and fewer problems in general (there are always exceptions).

"Rising interest rates mean higher CAP rates."

Because of another general principal in finance where asset returns are often modeled as some "premium" above a risk-free interest rate. As interest rates (generally measured by government rates that are risk-free) go up, asset returns also must go up accordingly.

You also see this in real estate in that when mortgage rates go up, the value proposition between renting and buying requires that rents go up also. Meaning, if rents stayed the same, it would be more cost-effective to rent rather than buy, and more people would rent, driving up demand, driving up rents, driving up returns.

Note that these are principles and not set in stone, so you may see exceptions. You may also see differences between markets (e.g. California and Nebraska) that have other explanations, but in general it should hold. In California, for example, where house prices are significantly higher, rents are also higher, but CAP rates (relative to the value), may be the same as Nebraska just because of the return required by landlords.

  • Wouldn't higher rents mean a higher CAP rate though? Also, you do seem to have a phenomenon where people are flocking to investments in markets like California, where the land is a huge component of the price, arguably deflating the CAP rate artificially, no? Or is the idea that the price already captures perceived risk in that market?
    – fox
    May 13, 2022 at 0:30
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    It depends on the value of the property. A $1M house that rents for $10,000/mo and a $100k home that rents for $1,000 a month have the same cap rate.
    – D Stanley
    May 13, 2022 at 0:39
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    And I'm not certain of the detail in the second question, but the cap rate is dependent on the total value of the property, including land and house, so it does not "deflate" the cap rate .
    – D Stanley
    May 13, 2022 at 0:40
  • Sure, I'm just saying that in the Northern CA market, the land is the overwhelmingly large portion of that total value, and that because of this fact, it may create a situation where CAP values are lower than a comparable property with similar construction and rents in, say, Nebraska. Or is the idea that the market is also communicating that comparable properties between the two jurisdictions are less risky in CA than Nebraska and that is reflected in the CAPs?
    – fox
    May 13, 2022 at 0:51
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    I don't know that the breakout of land and dwelling has a big impact - like I said, a $1M house that rents for $10,000/mo and a $100k home that rents for $1,000 a month have the same cap rate. The breakout of land/dwelling cost is largely irrelevant. It could be an house that costs $80,000 to construct in both cases and the math would be the same.
    – D Stanley
    May 13, 2022 at 1:14

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