California Real Estate Practice Exam

How would the capitalization rates compare between two buildings leased to different tenants, one being a retail store owner and the other a federal government agency?

1. Cap rate on federal building would be higher

2. Cap rate on federal building would be lower

3. Cap rate would be lower on the retail store

4. Cap rate would be the same for each

The correct answer is: Cap rate on federal building would be higher

The capitalization rate, or cap rate, is a key metric in the real estate industry used to assess the value of an income-producing property. It is calculated by dividing the property's net operating income (NOI) by its current market value or purchase price. In analyzing different tenants, the perceived risk associated with them greatly influences the cap rate. When comparing a building leased to a federal government agency to one leased to a retail store owner, the cap rate on the federal building would be lower. This is because leases with government tenants are generally viewed as more stable and secure due to the financial reliability of the government. Investors typically perceive less risk with federal leases than with retail leases, which can be subject to economic fluctuations and changing consumer behaviors. Consequently, the lower perceived risk associated with the federal building leads to a lower cap rate, signifying a higher property value, as investors are willing to accept a lower return on investment in exchange for reduced risk. In contrast, a retail store, while potentially profitable, may experience higher operational risks related to market conditions and consumer trends, which investors account for with a higher cap rate. The distinction in tenant stability fundamentally explains why the federal building would have a lower cap rate, reflecting its safer investment profile.