Why do cap rates vary so much from geographical area to area?

In San Jose 6-7% cap rate is high but in Florida you see them for 26% and 20%.
Why is there such an enormous difference between geographical areas around the country?
In Buying Property - Asked by max s. - Oct 27, 2011
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Answer(s)

Cameron B.
Broker/Agent
San Francisco, CA

CAP rates typically take into account in-place and pro-forma income but do not address other risk factors such as vacancy rates, local economic factors such as unemployment and job growth, and future metrics including local development and urban infill/availability of product. Therefore the market usually reflects these in pricing and CAP rates. Florida is experiencing a tough residential market combined with higher costs for insurance and taxes (due to hurricane and natural disaster expenses) so investors are likely to try to unload product with a higher return (and a higher risk). Florida agents - step in here as I am on the wrong side of the country to talk specifics about Florida.

Oct 27, 2011
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Werner K.
Appraiser
Hudson, OH

Capitalization rates as used on loop net usually refer to what is more technically known as a Direct Overall Capitalization Rate (sometimes called a Cap Rate, Overall Rate (of return) or Overall Annual Rate or OAR. Basically, the Cap Rate is Net Income (or Cash Flow Before Debt Service or sometimes Earnings Before Interest, Depreciation, and Amortizantion (EBIDTA). Or more simply Cash Flow before Mortgage Payments divided by the amount of the Investment (or price divided by value). Variations arise because the term cap rate means something different to different people.
Sometimes a cap rate will refer to a yield capitalization forecast over an extended period of time, often a 10-year forecast. This cap rate is a discount rate or internal rate of return.
Sometimes a cap rate refers to an equity dividend rate or cash return on cash invested. Because of financial leveraging these quoted returns are often much higher.
Sometimes a cap rate will be based on last years cash flow, sometimes it will be applied to next year's anticipated cash flow. Someone might base the cap rate on an income produced by a property that is only 65% occupied. The next person will say, oh but that property could be 95% occupied, and forecast income on that basis. Thus the cap rate will be much much higher.
I have seen smaller properties sell at prices based on last year's expenses where an owner has been milking the property. The mom and pop owner does not include the cost of his own time in managing the property or doing repairs, and has no allowance for reserves or turnover vacancy, and no allowance for payroll.
These properties will be advertised with very high cap rates. The more realistic cap rate would be much much lower.
All things being equal, the cap rate is a risk adjusted rate of return. While it is based on a single year's income, it reflects the market's assessment of the quantity and quality of anticipated cash flow, both current and in the future. The properties in San Jose probably reflect tight market conditions, strong growth potential in rents, and the limited possibility of entry of competitive new supply.
Florida cap rates reflect the distressed nature of the market with owner's and banks unloading properties at distressed properties. They reflect the prospect of limited upside potential to increase rents if the market is oversupplied and not growing (as fast as it once was).
In Cleveland the population has declined from over 900,000 to less than 400,000 since 1950. Imagine half the population of a city is gone and the impact that has on investor's perception of the market. Thus, in the City of Cleveland, investors will command a premium because it is likely there will be less demand for property 10 years from now, and that prices will be lower (if trends continue). Investors need to get their return on investment and return *of* their investment a lot faster because they might not get their money back at the end of their holding period.
The cap rate reflects risk associated with on-going returns. If the property is operating with thin margins the cap rate will reflect a higher risk and will require a higher cap rate. A triple net leased property leased to Walgreens will command a much lower cap rate.
Its important to know exactly what rate someone is talking about when they are talking cap rate, and also know exactly what income they are talking about in order to derive that cap rate. Does the income include an allowance for reserves? allowance for management fee? adequate allowance for expenses? vacancy? etc etc.
Is the rate an equity cap rate or an overall rate? is it a direct cap rate or a yield cap rate?
It's easy to throw around a cap rate but hard to back it up. Be sure you know exactly what a peson means when they say cap rate and what revenue and expenses are included in the income upon which that cap rate is based.

Oct 27, 2011
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