CAP Rates and Percieved Risk

In the Seattle apartment building market, risk can be defined as the uncertainty with respect to an apartment building’s income-earning capacity and value. Investor risk perceptions regarding the prospects of an apartment property are influenced by the economic and apartment market conditions prevailing at the time of the purchase, especially with respect to household income and population growth, as well as apartment supply growth. All else being equal, one would expect that when the apartment market is strong, with climbing rents, high levels of absorption, and decreasing vacancies, investors will feel less uncertainty about apartment property future cash flows and appreciation prospects. This lower uncertainty will translate to lower apartment risk perceptions, allowing investors to accept lower returns and, therefore lower apartment cap rates. Market CAP rates will compress or decompress in reaction to these perceptions and economic conditions as shown by historical results.

Besides the effect of broader apartment market conditions in the Seattle metro area, the investment performance of an apartment property is also affected by property-specific and location factors. Hence, these location and property-specific factors also shape risk perceptions and the cap rate that may be used by an investor in determining the price he/she is willing to pay for an apartment property. For example, an investor may consider a 30-year-old apartment building as more risky than a new one because of greater risk of functional obsolescence and greater uncertainty regarding the building‘s required maintenance expenses.

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