CAP rates, risk, and interest rates

Question

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?

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.