For a stabilized property, should the cap rate be lower because its more secure, or higher because there is less upside?
My understanding is that cap rates capture a number of factors. One factor is the stability of the cash flows. For example, if you have a NNN leased property with a 15 year lease term, that's going to trade at a pretty low cap rate because it's so secure.. it's basically like a bond.
On the other hand, if there is significant upside potential in the rent, that could also drive a lower cap rate, just as significant downside risk would raise the cap rate.
So let's say you have an office property that's 100% leased with no real upside potential. On the one hand, it's stabilized, so in that sense it's more secure. On the other hand, it has less upside potential than other office properties that are maybe acquired with a reposition strategy in mind to get higher rents.
So where would you expect to see the cap rate for the stabilized property versus other properties that have higher upside potential? What is the correct way to think about this?
Thanks for your thoughts/insight.
Potential upside still means the new owner has to take action to capitalize on it, which equals risk.
The degree of that risk is subjective though, for example if you have a strong network of potential tenants and get verbal commitment before making an offer, you might assess that risk as negligible.
To answer this, you need to consider the difference between an in-place cap rate and a stabilized cap rate. On a stabilized basis, the cap rate for the property with more upside potential (risk) should be higher than a property that is already stabilized (less risk) or you are not being adequately compensated for the added risk.
In-place cap rates do not tell the entire story and are often misleading as they do not consider potential upside by definition. Assuming the upside is fairly well defined and recognized by other market participants, it's possible and even likely for a property with substantial upside to trade at a lower in-place cap rate than a stabilized, core asset. The expectation of the buyer is that this property will stabilize at a higher yield than the stabilized, core asset, even if they must purchase at a lower "going-in" yield. This is why you might see a shiny new tower trade at a higher cap rate than the crappy looking property next door - perceived upside.
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