Why is a higher Cap Rate considered more risky?

Cap rate is a valuation multiplier, the literal inverse of a price/earnings ratio (if you like stocks). Thus, more risk = higher cap rate, all else equal. It is also impacted by growth and overall cost of capital (i.e. bonds). Essentially, you can look at cap rate data as a measurement of the priced risk of the asset, higher cap rates for riskier deals (based on market pricing). 

Risk and reward should always be commensurate in any investment you make, including in real estate.  Higher yield (cap rate) is not dissimilar from a higher yielding corporate bond vs. a low yield (cap rate) and UST.

The question is, what would determine how much money you would pay for a given $ of cash flow.

Let's say you have a building that generates an NOI of $1. If the cash flows were very secure (long leases, below market rent, highly credit-worthy tenants), you would pay more for that cash flow, which mathematically implies a lower cap rate.

If the $1 of cash flow is very risky (short lease, above market rent, tenant could go under any day now) you'd be far less willing to pay up for that cash flow--the asset would be worth less. Put another way: a buyer of this property would demand a higher cap rate to compensate for the risk of declining cash flow.

Think of the real estate asset like a bond: if it's safe, you are willing to accept a low interest rate (low cap rate). If it's risky, you demand a high interest rate to offset the risk (high cap rate).

Risky things are worth less money.

Here are some examples to help think of it too:

1) A new, fully leased apartment building in a submarket with consistent rent/demographic growth and minimal competition generates $1 of NOI and sells for $20.  This 5% cap rate reflects that it is a lower risk deal.  You feel very strongly that that $1 of NOI will be easy to maintain and will likely grow in the future.

2) An old Mall is 70% leased and having trouble attracting new tenants, and its anchor tenant which represents 30% of the property is struggling, sales are declining YoY, and there are rumors its headed to bankruptcy (its losing customers to amazon and also located in a submarket that with negative population growth).  The leasing team has reached out to dozens of potential replacement anchor tenants and none have expressed interest.  The remaining in-line tenants are doing okay, but a few have lease expirations coming up soon and have already requested rent reductions since sales are declining, a few have indicated they will probably vacate, and several also have co-tenancy clauses which allow them to vacate if the anchor tenant leaves.  The mall generates $1 NOI and sells for $5.  The 20% cap rate reflects how risky it will be, and how much work it will take to increase/maintain the current level of NOI, and that in all likelihood NOI is going to decline in the future.

So while that 20% cap rate in #2 sounds nice (I make my money back in 5 years!) it actually reflects how incredibly risky that income stream is, and there's a good chance that mall is only generating pennies on the dollar in a few years.

I like to think of a cap rate as being made up of a few different components: the risk-free rate (10 year UST), a risk premium, a liquidity premium, as well as future growth expectations. Every US real estate deal has the same risk-free rate and you start to "build up" the cap rate from there. What the relative risk of the deal/asset class/market/etc. will add a premium to the baseline UST, as will liquidity (ie, MF in Manhattan is inherently more liquid than office in Alabama and thus commands a lower liquidity premium). Lastly, you also have to factor in growth expectations into the equation, because in an asset in a market with higher growth expectations will command a lower cap rate than an identical asset in a lower growth market.

In a sense, it's similar to why Treasuries are lower yielding than junk bonds: you have the faith and credit of the US behind Treasuries, like a great and sure cash-flowing property (class A office in a major CBD for example, or whatever else is in vogue). The same cannot be said about junk bonds, which are like high cap rate SNFs out in the boonies (or whatever else is really not in vogue).

So the cap rate is equal to the discount rate plus the growth rate. Cap rate = discount rate + growth rate. Assuming you have the same growth rate in a market (let's say 2%), the only thing that would be change in this scenario is the discount rate. A discount rate is basically the certainty of cash flows. A certain cash flow aka a safer investment with long term leases and credit tenants might have a 3% discount rate. The cash flows are not 100% certain, but you're very likely to see them from a credit tenant in a Class A asset. Where certainly is not as likely could be in a lower quality asset of the same type where a lease is expiring soon, in this case the future cash flows are not as certain and you don't know what you'll be able to lease it for in the future. Let's say this one  has a 5% discount rate since there is more uncertainty. The safer asset comes out to a lower cap rate of 5% and the riskier one comes out to 7% cap rate. 

You would still calculate the cap rate like you did (NOI/Purchase Price), this is just so you understand what's driving a cap rate. I would recommend Peter Linnemans textbook as a good place to learn more about these topics in detail.

Hope that helps and if I got any of this wrong, please feel free to correct me. I am learning as well and I believe I have this concept down, but wouldn't want to mislead anyone.

A very simple way to understand it would be to compare it to the P/E ratio in traditional finance. The higher quality / less risky a company is, the greater the multiple will be. The only difference is the ratio is inverse - so a property that is of higher quality / less risk will trade at a lower cap rate.

just came to this thread looking for ideas for 50-cap asset types

why are people still trying to explain it after it's already been explained